Capital Allocation: Buybacks
Our thought leadership over the past two weeks has addressed inflation and supply chain disruption. With the Suez Canal crisis proliferating that theme this week, we are gearing up for supply chain to be the #1 topic this upcoming earnings season.
This week, we pivot to another critical topic – one that is often controversial in the boardroom and in the media – share buybacks.
Capital Deployment
Our thought leadership over the past two weeks has addressed inflation and supply chain disruption. With the Suez Canal crisis proliferating that theme this week, we are gearing up for supply chain to be the #1 topic this upcoming earnings season.
This week, we pivot to another critical topic – one that is often controversial in the boardroom and in the media – share buybacks.As we have noted for the last several years, free cash flow generation and effective deployment continue to grow in importance and serve to positively differentiate companies that have demonstrated strong, consistent execution in this area. Indeed, Capital Allocation is one of the Corbin Critical Five investment factors, identified as part of our proprietary buy side research over 13+ years.
Following the onset of the COVID-19 pandemic, we noted in our May 2020 “Close to the Quarter (Q2)” that in addition to the “Wheat Separating from the Chaff”, two key trends we expected were:
- Bullet proof balance sheets were here to stay across the cycle
- The downturn playbook for this crisis was fundamentally different than the Financial Crisis of ’08-’09, one key component being that instead of “cutting to the bone,” experienced management teams would apply lessons learned and focus their efforts on reinvesting for growth and positioning their companies for long-term success
Fast forward 12 months, reinvestment and debt reduction have remained the top two capital deployment preferences for institutional investors and analysts surveyed as part of our quarterly Inside The Buy-Side® Earnings Primer.
Indeed, for the last 6 years, we have tracked institutional investors and analyst preferences, asking them to rank the preferences on uses from highest to lowest priority. The results? 6 consecutive years where reinvestment and debt paydown have been the leading first and second priorities. The following chart normalizes percentages for each capital use, where a larger area equates to higher priority relative to other uses. Except for dry powder (i.e., stashing cash) increasing in March 2020, no use has seen nearly the same level of preference as reinvestment and debt paydown.
Following those two preferences, companies are left primarily with 4 choices:
- Hoard cash
- Grow the dividend
- Repurchase shares
- M&A
What really strikes us is that buybacks have remained among the bottom two uses for the past 6 years, and often the lowest priority, even in periods of declining share prices (e.g., late 2015). Even more, every quarter since COVID-19, investors have even prioritized hoarding cash over buybacks. To understand why, we conducted an analysis of investor commentary in our Corbin Universe database.
Setting the Stage
Buybacks
With S&P 500 companies sitting on more than $2.7 trillion in cash to end 2020, 20% more than they had in 20191, investors are looking for companies to put their cash to work – after reinvesting for growth, of course, and addressing debt levels, if that is an issue.
Regarding buybacks, last year, our proprietary research found more than one-third of S&P 500 constituents suspending buybacks by June due to the Pandemic and, by year end, companies had spent 29% less on share repurchases than in 20191. However, a renewed focus on share buybacks is emerging – Q4 2020 saw a 28% increase to $130.5B for the S&P 500, Treasury Secretary Janet Yellen on Wednesday noted banks have improved their capital positions and should be allowed to continue to buy back their own shares, and Warren Buffet in his Annual Shareholder Letter provided perspective on the power of share repurchases (“we made purchases because we believed they would enhance the intrinsic value per share for continuing shareholders and would leave Berkshire with more than ample funds for any opportunities or problems it might encounter”).
Still, preliminary results for our Q1’21 Inside The Buy-Side® Earnings Primer® again finds that institutional investors continue to deprioritize buybacks. The key questions are, “Why?” and “For what companies do we see elevated appetite for buybacks?“
To answer this question, we analyzed our database, which included more than 3,100 mentions of buybacks.
As noted above, when asked for their preferences broadly, investors favor reinvestment and debt paydown more than 2x, and in many cases, 3x as much as buybacks. However, when looking at investor views on specific portfolio companies as part of our Perception Study research, preferred uses are recognized at varying levels based on the company profile, which we bucket into four key profiles:
Acquisitive Companies: "The Acquirers"
History of acquisitions and/or strong M&A appetite. Investor preference:
- Acquisitions
- Reinvestment
- Buybacks
Non-Acquisitive Companies: "The Steady-Eddies"
Limited M&A appetite, income-paying or defensive
- Investor preference: balance of reinvestment, buybacks, and dividends
- Companies typically have strong balance sheets; few see debt reduction
Underperformers: "The Underperformers"
Bottom 25% of companies, which saw 37% share price decreases over a 3-year period leading into the perception study:
- Investor preference: 1) buybacks; and 2) debt paydown
- Companies typically have distressed share price or undergoing a turnaround
- Significant overlap with “The Leveraged” group
Debt Ladened: "The Leveraged"
Companies with debt levels identified as a company weakness:
- Investor preference: debt paydown
- Companies primarily had debt levels >3.5x Net Debt-to-EBITDA
The two company profiles with elevated investor appetite for buybacks are The Underperformers and The Steady-Eddies. And, interestingly, The Acquirers and The Leveraged see similar buyback preferences of 34%.
To better understand why investors consistently rate buybacks the lowest when asked to rank their preferences in general, we analyzed our – Corbin Analytics database.
The top reason why investors do not favor buybacks broadly is because they believe management teams are not effective at timing share buybacks at appropriate prices
“A consistent repurchase strategy is what you want to see because they’re never going to be good at timing their stock, as most companies are not.”
“Opportunistic shares repurchase is very beneficial. A lot of companies end up buying too much stock at too high of a price. I get that it is clear after the fact and not as clear in real time.”
“I am not suggesting management buy the stock back at 20.0x earnings but it definitely feels like when there is excess FCF, they buy back more, almost irrespective of price.”
“Technology investors learned the past three to five years that technology companies are no better at buying their stock back at good times in the market then regular investors. I realize we had a scary downturn but every one of the technology companies I followed that had buybacks in place put them on hold and it was a good buying opportunity.”
“There are times when buybacks are appropriate, but they tend to be executed at the wrong time.”
“Companies are not very good at it.”
“I encouraged them to buy back their stock when it was at about a third of the price of where it is now and they weren’t receptive to doing that.”
For many investors, compelling M&A that advances the company’s strategy is viewed as a better use of cash but in the absence of M&A, they prefer buybacks
“Continue to be opportunistic; it depends on the level of accretive M&A they can find first.”
“That depends on if they see good M&A in the pipeline. For a business of this size, they’re better off doing smart M&A and repo should be done if they don’t.”
“If there are no inorganic growth initiatives, then stock buybacks.”
“Share repurchases have to be weighed against M&A first.”
“They should buy back stock when there are no good deals so it shows that they will not make deals at high prices.”
“They should buy back stock in the absence of tremendous deals.”
“A buyback would add shareholder value if an acquisition opportunity does not come along that makes sense.”
Investors most often favor buybacks for the following situations, which are not mutually exclusive:
- Taking advantage of short-term price dislocations
- When undergoing a transformation or turnaround strategy, as it demonstrates conviction in the long-term vision
- When there is no compelling M&A, a company is digesting a transformational acquisition, or has a poor M&A track record
- To offset dilution / options creep
- In periods of low cyclical demand when the cycle is nearing a turn
- When flush with cash
“…to take advantage on some of the volatility in the stock.”
“If investors knew when the stock went down that the company would aggressively buy back stock, then I’d hold it.”
“If the stock were to go down 10% from here, they should have the flexibility to step up their buyback materially and do it opportunistically.”
“We would like to see a more sustained buyback at these stages, especially where valuation is at right now. It is trading at 52-week lows. The last time it hit these levels was 2012, so a buyback at these levels definitely makes sense.”
“Having a share buyback to support the stock if there is a hiccup on a quarter isn’t a bad policy.”
“I recommend a more consistent buyback. If management really believes the story, the stock could double in the next 18 months. It will have a lot more earnings power then.”
“If they really believe in their strategy, they can buy back stock at this valuation.”
“If this grand plan is so perfect, then its stock is the cheapest it will ever be and the company should be using its free cash to buy back stock.”
“Management could buy back more stock. If they think the stock is cheap and buy back shares, that sends a signal to the market about their strategy.”
“If they felt comfortable with their business, a buyback would go a long way to show folks that they can do shareholder-friendly initiatives.”
“I would rather see them opportunistically buy back stock than make acquisitions until it’s gotten through its restructuring program. That’s the business it knows best. The business you know best is the one you own when you buy back your own stock.”
“They should definitely return cash to shareholders via dividends or buybacks because I have not heard management talk about the need to make acquisitions or the strategy behind acquisitions.”
“They have done a fair amount of M&A, so they should digest what they have and put some money toward a buyback versus making more acquisitions.”
“…they should keep the anti-dilutive share repurchase program in place; that should be the top consideration.”
“The occasional buyback for dilution is fine.”
“They need to at least buy back shares to offset dilution because there are quite a lot of options out there.”
“They need to buy back some shares to stop share creep.”
“In times where stocks get crushed and if we get more clarity on where the end markets are going to be, then share repurchases are attractive.”
“If the stock has gotten beaten up because of the low cyclical demand and they believe the cycle will turn in a reasonable period of time, they might want to be opportunistic and pounce on the depressed stock in terms of buybacks.”
“Presumably, the stock is a lot lower in a period of low cyclical demand, so I would want them to buy back stock.”
“I hope they can return some cash to shareholders and suggest they do it via share repurchases countercyclically.”
“I would like to see some progress on the share buyback or potential expansion…with the potential for increased cash on the books.”
“They are going to be generating a lot of FCF and they can buy back their stock and people will not be able to ignore that.”
Investors express the most concern regarding buybacks when:
- Buying back shares at high prices
- Announcing a large buyback program and then not buying back shares at cheap prices
- Being too aggressive with buybacks and leveraging as an EPS growth tool too often
- There is low trading liquidity to begin with
- Management addresses “cheap” valuation with investors but does not buy back shares (note: we recommend treading lightly on valuation, as this is a prevalent buyside pet peeve; we have deployed strategy around addressing valuation, but the scenarios are very specific)
“…the company authorized a buyback when the stock was very cheap and only executed [half] of that when they could have bought much more.”
“They approved a share buyback and bought back very little stock.”
“The stock is undervalued. The company does not appropriately allocate its capital and it should buy back its stock. Since it does not buy back stock even though it has an authorization in place, it hurts management’s credibility in the market.”
“I’m skeptical of companies that do big share repurchases. That’s usually a sign that they don’t have any other way to grow their earnings.”
“I am always wary of buying too much at too high of a price to try and meet earnings.”
“Most people will say to buy back stock because it increases earnings on a no-brainer basis. If you know how to invest to sustainably increase organic growth, then that has the best multiplier.”
“…I don’t agree with share repurchases; they are already too illiquid.”
“I want them to buy back stock but, at the same time, it is illiquid, so it is hard to build a position.”
“It is not big or liquid enough that it should be a big part of their capital allocation priorities.”
“Buybacks are not always the best option for smaller companies because they might be up against trading volume constraints.”
Normally, the best thing they can do is support their share price, which would be a share buyback at these types of returns. The problem is they are not highly liquid to begin with, so that makes it tough to put a massive share buyback in place.”
“Management is always talking about how they think the stock is trading at a meaningful discount to their perception of asset value. If that is the case, then it is most meaningful to buy back the stock, but they haven’t.”
When it comes to buying back stock, investors encourage companies to reference book value
“The companies that are buying back shares are looking out for their shareholders. I am talking about those who are taking capital and buying shares below book.”
“Buy back stock when it trades at a significant discount to book value.”
“If the stock trades below book value, it should repurchase shares.”
Most companies do not excel at buying back stock. While there are challenges associated with this, including narrow windows and less than airtight execution, we look at buybacks as the next frontier of capital deployment effectiveness and competitive advantage building.
We have assisted many clients with tightening their buyback strategy and communication approach and a few best practices include:
- Develop a valuation model that serves as a trigger to buy back stock; closely monitor book value
- Communicate a clear share repurchase policy, including whether the policy is opportunistic, programmatic or in place to offset options dilution
- Communicate the board-approved authorization level (dollar or share amount)
- Provide quarterly updates on share buyback activity
There is a perception wall – as we call these types of sentiment situations – around buybacks that must be changed. To do so, management teams must increase investor confidence in their ability to leverage buybacks as an effective value creation tool by providing perspective on how they evaluate the intrinsic value of their corporation and will execute disciplined buybacks at the appropriate levels.
In Closing
We are passionate about serving as a strategic advisor and giving our clients a competitive edge. Capital Deployment is serious business, and every company should be developing systems and processes to confidently communicate investment impact – supported by specific KPIs associated with each use – to the Street. Buybacks must be the next frontier to conquer – after all, your stock is your currency!
Source: S&P Global