This is one of those questions that some of you are asking me from time to time. And an answer to this question about share buybacks is not easy, because it really depends on the context.

Hence, today I would like to share with you the situations in which I’m supportive of buybacks and those in which I prefer a company to make other capital allocation decisions.

But let’s touch on the basics of buybacks before I will share with you my opinion.

What do stock buybacks mean?

A stock buyback is an event when a company uses its cash to buy back its own shares from the open market. The result of a buyback is typically a reduction in the shares outstanding.

Shareholders often consider this as a good thing, because it means that they will increase their stake in the company. Which in return theoretically means an increase in share price.

As you can imagine, stock buybacks are therefore also an important form of capital allocation by the board of directors.

And with capital allocation I mean the decisions an executive makes on how to spend it’s money that they have just earned from selling their goods and services. The classic ultimate goal for any executive is to increase a company’s efficiency and to maximize its profits.

In this context typical available capital allocation considerations to be made by the board of directors are:

• Investments in Research & Development
• Acquisitions of other companies
• Growth investments (i.e. via marketing)
• Distribution of dividends
• Distribution of special dividends
• Stock buybacks (also called Share Repurchases)

As you can see, there are quite some options available to a CEO to grow wealth for its shareholders. But this is also why the role of a CEO can be so complicated at times.

In my opinion a CEO has a very difficult task to continuously make the right capital allocation decisions to earn the highest Return on Investment possible.

Just compare the differences in impact on shareholders that Satya Nadella (CEO Microsoft) or John Stankey (CEO AT&T) had based on their past capital allocation decisions. I think the results speak for itself.

But if we look at share repurchases, then there’s really something awkward about it, because they seem to be way more popular than for instance investments made in R&D.

Therefore it is In this context also very interesting to understand why share buybacks are so popular.

Why are share repurchases so popular?

This is a very interesting question to answer, because share buybacks were really not common up to the 1980’s. Actually they weren’t even legal until 1982.

But in those times, the main reason why companies would typically buy back their shares was to protect itself from corporate predators.

Cash rich companies are always companies that attract a lot of interest from potential buyers. Thus it was effectively a defense mechanism to protect against violent and unwanted takeovers.

But as you can see in the picture below, this really started to change around 2004.

The general consensus is that it has changed since then and especially due to an increasingly favorable interest environment.

A precedence was being set and many companies followed during those times.

It then really became a trend in the corporate world and it supported the philosophy that companies only exist to maximize wealth for their shareholders (Milton Friedman).

One could argue that one of the biggest beneficiaries wasn’t necessarily the shareholder, but the board of directors themselves.

Many CEO’s and other board members are compensated by stock options and dependent on how their share price performs.

Hence, buying back shares is probably one of the easiest and powerful ways to manipulate your own share prices without putting too much effort into it.

Having said that, there are many other reasons why buybacks are so popular, but I believe that this incentive for a CEO is probably one of the biggest reasons for it. 

So let me therefore share with you my thoughts on when I think share repurchases make sense and when I generally disagree with them.

When I think stock buybacks are a good capital allocation decision

1. When the share price is undervalued

Price is what you pay, value is what you get is something Warren Buffett often says an this is exactly how I think about share repurchases. 

For me it mainly makes sense to repurchase shares if you strongly feel that your company is trading at a discount to it’s fair value.

It allows you to effectively buyback shares for “90 cents that are worth a dollar” and this is one of the best situations in which a company is actually creating shareholder value.

But the trick is in the fair value price estimate of a company. How does a CEO what the real value of their company is? Aren’t they biased?

Well, I firmly believe that it is hard to value a company and I’m sometimes leaning more towards the philosophy of it being and art than the result of a mathematical model (which I handsomely apply myself 😅)

But I do think that it’s possible and a great example is Berkshire Hathaway. They have been quite vocal in what they believe their fair value for their company is and they used to relate it to their book value.

At the same time they communicated to their shareholders that they will consider repurchasing shares if they price goes below that threshold. 

And so they did last year for one of the first times.

Excellent value creation for shareholders.

2. As protection against hostile takeovers

Sometimes there are companies which are ran very well and they are generating massive stable and growing cash flows that many other companies are jealous on.

And not only that, their balance sheet is pristine with a lot of cash and a debt/equity of nearly zero.

But that’s also where the trouble can start, because at the same time their cash is not doing a lot. It’s just hardly generating any return.

This is the moment a company is very attractive as an acquisition candidate, because another company will look at it and think:

I’d love to own that business and we have a great opportunity to leverage it up a bit and buyback “10%” of their shares.

In takeover language this is called: the company will be 10% accredative after the acquisition is completed.

Off course, there are several other reasons for such a takeover, but this is a very clear example to me. 

And it’s actually funny, because these are exactly the companies I would love to own as a dividend growth investor. I’m sure that most of these would pass my dividend stock screener.

But you don’t need to look too far back in history, because this is exactly what Unilever did after it received a 143 bln hostile bid from 3G Capital (supported by Buffett). Unilever Plc was really not happy with their proposed bit and quickly pulled all its levers to reject it.

But it also exposed that the company was very sensitive towards a hostile takeover and it therefore launched a program to better deliver value for their shareholders. It was called “Accelerating sustainable shareholder value creation”.

The capital allocation plan got accepted and the company shielded itself from other potential hostile takeover bids going forward.

3. No better alternatives for cash

This situation is probably a bit comparable to the hostile takeover situation, but in this case the company is proactive in creating shareholder value.

Imagine that this company is providing ample free cash flow which is moderately growing year over year. 

The company has a decent moat and it doesn’t require such large capital expenditures in the upcoming years to secure its future free cashflows. At the same time it has already a very conservative and flexible balance sheet. 

Last but not least, the dividend is also easily covered from the free cash flow and there’s just money left after paying their dividends.

In my opinion this is an excellent situation to start buying back shares, because it’s probably the best way to generate a return for their shareholders.

In my opinion a great example of such a company is Ahold Delhaize. It has been buying back 1 billion Euro in shares annually over the last several years.

And the good thing is that it has done this almost entirely from it’s free cash flow. Hence, it hardly used any debt to achieve this as can be witnessed on their balance sheet.

In such a case, share repurchases can be a very smart long-term shareholder enriching strategy.

To sum it up, these were 3 share buyback strategies including examples to which I’m very supportive. Let’s look also into a few buyback strategies which I typically disprove of.

When I think stock buybacks are a bad decision

1. Leveraging up the balance sheet to risky levels

I don’t mind this as a one-off and as long as the balance sheet stays attractive and flexible as a preparation for when the company’s finances are under stress: 

• an ecomonic crisis, 
• a large acquisition 
• technological innovation requiring investments into new assets to protect their market leadership

What I do mind is when companies are leveraging up their balance sheet via share repurchases in which it detoriates their flexibility.

The almost zero-interest environment has created an incentive to leverage up a company’s balance sheet in favor of creating economic value.

The math is really simple:

If the cost of the shares outstanding (Dividends + Return expectations) is higher than the cost of debt, then it seems wise to buyback shares via debt.

But I don’t agree with this narrative when it’s at the cost of the balance sheet flexibility.

A nice analogy might be the financing of your house. Would you feel comfortable to leverage up fully in debt by taking a 2nd mortgage on your house so that you can buy dividend paying companies which provide a higher yield than the cost of your mortgage?

If yes, by all means, do it 😉 

But I personally wouldn’t feel comfortable with it. 

• What if there’s a certain life event that requires me to have access to cash (i.e. hospital treatment, loss of my spouse)? 
• What if I get a great opportunity to invest in something (i.e. starting a new company) 
• What if I have a sudden major unforeseen other expense (i.e. replacement of roof due to storm damage)?
• What if the interest rates suddenly rise very sharply?

These 4 situations are either challenges or opportunities for which you will need financial flexibility in your household.

And it’s no different to a company. 

If interest payments start to make up the majority of your cash flows then there’s hardly any flexibility anymore and such companies have a very large risk to run into troubles when shit hits the fan.

A good example of this situation is AT&T. They struggled to finance the latest 5G auction which is an essential investment to protect their future cash flows. 

No wonder they had to spin-off TimeWarner again, because it also allowed them to offload a large part of debt.

Another example which seems less obvious, but where I have similar thoughts are Starbucks. 

I don’t understand why they are buying back so many shares while their balance sheet looks just horrendous. 

They even have negative equity right now after all the share repurchases and more debt than what their assets are currently worth.

This simple fact has made me drop Starbucks from my desired portfolio as I don’t see a place for such bad actor in my portfolio. And this is a perfect example of a great company, but a poor quality stock.

2. Large capital expenditures needed due to fierce competition

A really great example of this is IBM. 

Effectively IBM’s infrastructure business was at the heart of the company’s cash flow generation, but about 10 years ago it started to be cannibalized by new and upcoming cloud vendors (i.e. AWS).

What IBM could’ve done at the time was to start investing very heavily in building up their own cloud business. Instead, they have chosen to compensate shareholders with very fat share repurchase programs for their lack of earnings growth.

We are now 10 years later and their annual earnings are now more than half of what they used to be and the company is severely leveraged in such way that it lost it’s flexibility to do things. 

Off course, a 60+ billion Red Hat acquisition doesn’t help from a debt point of view, because a lot of that was goodwill (overpaying for RedHat?).

While the share repurchases sounded like a great plan for the short-term, the share price went nowhere over the last decade (long-term).

Even Warren Buffett bought this idea for a few quarters. But he couldn’t even imagine how quick he had to exit out again once he learned that he invested in a fundamentally broken company.

Now compare this to Microsoft which made different decisions a decade ago. It took a few years for the company to turn this into profits, but it is now the only company in the world that can come even close to Amazon with AWS.

The difference was really in their capital allocation decisions and the boldness the different CEO’s had. 

Who do you think was more concerned about the future of the company vs their own bank account?

Steve Balmer or Ginni Rometty?

3. Buying back shares to hide expensive employee option plans

The last, but not the least popular reason is to buy back shares to avoid shareholder dilution. 

A good sign of such behavior is when you hear year after year the CEO talking about their shareholder capital allocation program which includes share buybacks. But at the same time you don’t see the # of outstanding shares decreasing over the span of a several years.

Most often the result of this is an equivalent amount of shareholder dilution due to the issue of new share capital as a result of employee stock option expiration.

In this case we are again talking about misaligned shareholder needs vs the incentive a board of directors has. 

That’s also the reason why I prefer employee incentive plans to be expensed via the income statement just like as if they were salaries.

It makes the earnings much more cleaner and realistic instead of keeping it out of the books and painting the grass green with share buybacks.

Final thoughts about share buybacks

If you think about the last section, when I’m not supportive of share repurchases, then I still wonder why some CEO’s think that we are fools. 

Engaged investors that generally listen in into earnings calls and read the 10k’s will easily spot financial engineering via buybacks. People that are not engaged will neither know and learn about the buyback plans.

The real reasons why CEO’s can get away with financial engineering and shareholder misinformation is often due to:

• the support large institutional investors who are not looking after the retail investor, but for instance only their clients of their hedge fund that are trying to make a quick gain
• the sheer amount of small shareholders which prevents those investors to properly unite and raise a common voice of concern.

And CEO’s know this and if incentives are generally not aligned with long-term investors, then we can see all this kind of awkward behavior and self-enrichment.

If you are for instance not the founder of the company and the company isn’t your “baby”, then you might see your CEO tenure as an opportunity to maximize your own wealth over that of the shareholders.

That’s why I do pay attention to these kinds of topics like share repurchases, because it provides me with some evidence on whether the long-term shareholder interests are aligned with the incentives of the board of directors.

Hence, we just better hope that the CEO’s incentive aligns with us as shareholders.

And if they are aligned, then share buybacks done well could be one of the best shareholder enriching capital allocation decisions a CEO could make to pleasure us as dividend growth investors.

As an example, a 2% declining share count, while maintaining a stable absolute dividend already results in a 2% automatic dividend growth.

But off course, nothing beats organic revenue and earnings growth resulting in the highest quality dividend growth.

Yours Truly,

European Dividend Growth Investor