Until now the case for corporate stock buybacks has rested far more on faith than data. Whenever a company seems to lack better opportunities, its CEO or CFO will be pressured by investors to buy back stock, or will anticipate such demands by announcing a buyback program, on the assumption that reducing the supply of outstanding shares will send the stock price up. And that it often does. But are buybacks always the best allocation of shareholder capital? Absolutely not, a new study of buybacks shows.
In fact, return measurements that are typically applied to capital expenditures, mergers angod acquisitions and virtually every other use of corporate capital are rarely used to measure the value of buybacks, even though they consume equal or greater amounts of corporate capital.
The prevailing wisdom in favor of them has rested on one or more of the following rationales: 1) Buybacks provide management with the flexibility to cash in gains or leave capital invested; 2) The tax consequences of the alternative for returning capital to shareholders dividends are onerous; and 3) Buybacks automatically produce higher earnings per share (although this is purely a mathematical, non-operating result and overlooks the increase in risk that the leverage accompanying the reduction in equity may consequently produce).
However, actual measures that analyze the returns or losses that buybacks generate on invested capital are rarely marshalled as evidence to back up such claims. Buybacks are probably the least analyzed tangible event that companies spend so much money on, says Jim Morrow, Fidelity Research Equity Income Fund portfolio manager. Theres a lot of room to illuminate the effectiveness of buybacks.
Institutional Investors 2012 Corporate Buyback Scorecard does just that. Compiled by Fortuna Advisors, a New York City-based consultancy, the study ranks the biggest spenders on buybacks among the members of the S&P 500 based on the two-year returns their repurchases generated, as of last June 30, a period when stock repurchases exceeded dividends by more than two to one for all S&P constituents. The 253 companies bought back at least 4 percent of their market capitalization, which Fortuna deemed a minimum amount to be material. Using an approach much the same as any that investors employ to measure returns on other corporate investments, the rankings are based on the total return on cash expended on buybacks during that period, taking into account dividends avoided and the average value of shares at the end of each quarter.
Hallelujah, weve been looking for something like this, says Tom Kolefas, Manager of the TIAA-CREF Mid-Cap Value Fund. It opens a window on share repurchases just as we, and the Street, require a return on acquisitions or capital expenditures. You cant just say it was accretive. It has to post a satisfactory return on invested capital.
To illuminate how companies achieved their ROI, the rankings also measure how effective the companies have been in timing their purchases. Quite obviously, the more cash a company spends before its stock rises and the more it rises, the higher its ROI will be. But the study reflects wide variations in timing and results, a surprising outcome given managements freedom in this case to exploit inside information about its revenue, cash flow, earnings and other measures of corporate performance that shareholders care about.
Those variations are apparent in the studys measures of buyback strategy, which compares total shareholder returns with the average prices of shares in the prior quarter, their dividends and ending quarter average price, and of buyback effectiveness, which compares the difference between a companys ROI and its strategy. Companies that tend to repurchase shares when the stock price is lower than the overall trend demonstrate positive effectiveness, whereas those that tend to repurchase shares at prices higher than the overall trend demonstrate negative effectiveness. At heart, the studys formula shows ROI to be the sum of strategy and effectiveness.
Among the highlights of the studys findings:
The median buyback cost $1.18 billion and produced ROI of 7.7 percent. Across all 24 sectors, Telecommunications Services led the way with a collective buyback ROI of 38.7 percent. At the low end of the spectrum, technology hardware & equipment (-12.3 percent) trailed other sectors.