Mailbag on the math of stock buybacks (warning: this is a little wonky… it won’t hurt my feelings if you opt out now)

Amiable Reader writes:

Hi Jeff, love the article and financial insight. Just to play devil’s advocate (extra Pacino) for the moment, what happens if a company doesn’t retire its shares? I don’t believe it’s a requirement for them to retire their shares, but I could wrong on this. Does it depend on the buyback agreement? Would appreciate any commentary on this. Thanks in advance.

AR–

You can’t have your shares and buy them back too. If stock isn’t retired it counts for calculating EPS. Raising EPS (and the fallacious “supply and demand” argument) are the whole point of buybacks.

There are a number of accounting techniques for putting repurchased shares into suspended animation. As usual on Wall Street, the more you dig into them the more you realize they are complicated bc they are bullshit.

It’s pretty simple: If repurchased shares still exist as freely traded product they have to be counted for earnings purposes. That would make a company effectively long shares it could never sell; a purely speculative play by the BOD. No BOD wants that burden and history suggests they are right to avoid the accountability since boards’ timing is generally lousy despite literally infinite material non-public information.

But here’s the magic: if shares are retired they no longer have any tangible value that can be specifically footed to the trading value of other shares. Repurchased stock is dead and the cash is in the hands of the seller. Where once there was a liquid stock and cash there is now just cash. So half the previously existing economic value has been eliminated by the outstanding share count has gone down. Which is fine until you remember EPS isn’t a measure of financial health. Net income is. Long-term shareholders who seek long term value growth should threaten to burn down the HQ of any company even hinting at a repurchase.

What the company retains are debt load and interest payments. Companies very, very seldom flip from buying back stock to doing secondaries. Doing so would absolutely kill their shares. That means liquidity is restricted even beyond interest. So a buyback is financially tantamount to buying shares and lighting them on fire then paying an annual fine for pollution. If you’re lucky you’re interest rate paid on buyback loans is roughly equal to the dividend payments saved.

Companies are in a literal economic sense the worst conceivable buyers of their own shares.

In the short run there’s a case to be made for repurchases. Especially with the activist huckster salesmanship, having a company bidding for stock can give shares a boost. Which is exactly what you as investors don’t want to happen. You want dips. Those are buying opportunities. If I buy a dip I get to sell later, keep the profits and buy stuff. If a company buys its own dip it gains nothing (ex executives incented with EPS goals and stock options).

Competing with me in the marketplace for you own stock isn’t shareholder friendly. It’s bullshit. Buybacks steal investor profits in favor of nothing. Because, as we are be reminded this earnings season, there is 0 evidence that buybacks contribute to the longterm intrinsic value of a company.

By the time capital allocation f-ups kill a company the activists are usually gone. The exception is Berkshire where Buffett has chosen to keep the zombie shell of what used to be IBM on the books.

All you really need to remember is this: Every CEO bragging about how a stock has gone up during a buyback program is either an idiot or just begging someone like Warren Buffett to tell him he’s a good boy.

Comments »