What Makes Buybacks Effective Part II

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.
Warren Buffett
BerkshireHathaway 1984 Annual Report

I recently explored the notion of the stock buybacks:

What Makes Buybacks Effective?

This post essentially reviewed a Business Week article on buybacks that appeared in the January 23rd edition. My belief is that share buybacks need analysis as far as their “value-added” strategy. The questions that buybacks pose are: Is the company buying back stock below intrinsic value, is it reducing its cost of capital by restructuring its balance sheet, or is it merely sopping up stock that it issues through the exercise of (primarily) executive stock options?

This morning, I found that Michael Mauboussin, now of Legg Mason (working with Bill Miller, portfolio manager estraordinaire) and formerly of CSFB where he was one of very few Wall Street portfolio strategists that I read regularly, has put together a lengthy treatise on share buybacks.

He provides much historical content on the use of dividends versus share buybacks as ways to return capital to shareholders.

He utilizes one over-riding principle that echoes Buffett’s 1984 quotation:

“We can define a principle to serve as a universal yardstick for judging the rationale and attractiveness of a buyback program:
A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.
The first part of this principle—“a company should repurchase its shares only when its stock is trading below its expected value”—suggests management should act as a good investor by buying the stock when the price is below the value. Objective, analytical managers likely understand the business and its prospects better than outsiders, positioning them well to make this value-versus-price judgment. If price is truly below value, a buyback transfers wealth from selling shareholders to continuing shareholders. The resulting increase in expected value per share holds with management’s objective to maximize shareholder value for its continuing shareholders.
The principle’s second part, “no better investment opportunities are available,” addresses a company’s priorities. Buybacks may appear attractive, but reinvesting in the business may provide a better opportunity. Value-maximizing companies fund the highest return opportunities first.”

I hope you will find this rather lengthy discussion worthwhile!

Michael Mauboussin