More on Repurchases

I got a number of emails is response to yesterday’s screed against share buybacks. Here’s a thoughtful response from a reader.

First, I’m a fan of your blog, and read it every day. (I even own some NICK 🙂
I’m having trouble understanding your antipathy to buybacks.
If you believed (bear with me) that stocks were always correctly priced, then you would prefer buybacks to dividends for stocks in you taxable accounts because of the tax advantages. And this is true even if the nominal tax levels on dividends and capital gains are the same, because capital gains taxes can usually be deferred for a long time (maybe even forever, for example if you make a lot of charitable contributions), while dividend taxes are impossible to escape.
But of course stocks are not always correctly priced. In this case, you’d want the firm to buy back stock when the stock was cheap and issue stock when it’s expensive. Since the entire premise of your project is that you can identify cheap stocks, you should be happy to hear that one of your holdings is using their cash to buy back shares which you presumable believe are cheap.
You are a buy-and-hold investor, who will hold the firm for as long as it’s cheap, so you don’t need to worry about whether the buyback is immediately correctly reflected in the stock price…the buyback will increase earnings-per-share, and this will eventually be reflected in the price.
This also helps get rid of the excess cash which might otherwise be squandered by the firm. You could also do this via a one-time cash dividend, but then again there would be a big tax hit. You could raise your regular dividend, but then you might find you have to cut it, and firms are reluctant to do that for signaling reasons.
Of course the problem with buybacks is that firms might do them when the stock is expensive. In theory, executives should be able to use their inside knowledge to do more repurchases when the stock is cheap, but it’s not clear how much that really happens. Also, what is seen as “cheap” changes with the overall level of optimism in the economy.
But again, since you believe you can identify and hold cheap stocks, you should be happy when one of your holdings makes a purchase of cheap stock on your behalf. What am I missing?

It’s hard for me to argue against this because everything he says is correct. My stand against share buybacks is far more primal. I just want the cash, and I’m happy to leave the theory stuff to someone else.
If it’s not advantageous tax-wise, fine—change the law. If the stock is still cheap, fine—give me the dividend and I’ll decide if I want to reinvest it or not. I just want the money.
David Berman, who writes the terrific Market Blog for the Globe and Mail, writes:

Mr. Elfenbein’s argument would be a lot stronger if he could show that companies are notoriously bad at timing share buybacks – that is, buying their own stocks at high prices and therefore wasting their money.
According to Standard & Poor’s, companies in the S&P 500 bought $47.8-billion (U.S.) worth of shares in the fourth quarter of 2009, up more than 37 per cent from the previous quarter. However, this is still well below the frenzy of buyback activity in 2007, a year that coincided with a peak in the S&P 500 before the onslaught of the financial crisis.
Companies, it seems, like their own shares when they’re pricey.

For me, it’s a point of principle (and principal, for that matter). I don’t want the companies I own to be in the business of timing their stock. That’s my job. Their job is to run the business and make as much money for me as they lawfully can. I’m the owner. Let me worry about what to do with the profits.
Another reader writes:

I definitely agree with you on preferring dividends compared to repurchases, at least in 99% of cases. You cited the case of Cisco, which has spent tens of billions to no apparent effect. The more pernicious thing about repurchases is that many companies only use them to soak up the equity dilution from option issuance to employees. Yet billions of dollars are spent on repurchases, without actually shrinking the float. Take a look at the recent Goldman Sachs quarter; they spent a couple of billion buying back 13.2 million shares to offset option issuance, but actually had 16 million more average shares outstanding (basic) and 6 million more shares outstanding (diluted) at the end of the quarter, compared to the end at Dec. 31/2009.
I’m not sure if all companies are now required to report EPS including option issuance as compensation expense; if they are, that’s fine. But if they’re not, then companies get to boost EPS too, by diverting an expense item into the balance sheet item of retained earnings.
Give me the dividend!

This is an excellent point. I don’t mind executives being compensated with stock, but share repurchases make it very easy for them to mask shareholder dilution.

Posted by on May 6th, 2010 at 9:53 am


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