The Ugliest Part of the Buyback Bonanza

A confounding topic for many investors... Are stock buybacks good or bad?... How Macy's made $18 billion go up in smoke... When buybacks become a disaster... Even the best capital allocators can get this wrong... The ugliest part of the buyback bonanza...

Some financial topics confound investors no matter how much they're discussed...

Take "stock buybacks," for example.

Also known as share repurchases, it's when a company buys back its own stock in the open market. A buyback reduces the number of outstanding shares available to investors.

Regular Digest readers know buybacks can be great for investors when used appropriately – when a company's shares are trading for cheap and it has enough extra cash to buy them.

Under the right conditions, Berkshire Hathaway CEO Warren Buffett believes they're the best thing a company can do with its cash.

But not everyone feels the same way...

Democratic presidential candidate and Vermont Sen. Bernie Sanders unveiled a plan last week to ban share buybacks altogether. He argued that they constitute stock-price manipulation and "provide absolutely no benefit to the job-creating productive economy."

Recently, I (Dan Ferris) have received several questions and comments about buybacks from Stansberry Investor Hour podcast listeners. (I addressed the topic last week.) And the questions have all generally revolved around a simple one... Are they good or bad?

But the thing is, the answer isn't as simple... Share buybacks can be good, as Buffett believes. But as you'll see in today's Digest, most companies don't use them properly...

Most companies tend to buy back tons of their own stocks near market tops. And they don't do it at market bottoms, when they probably should be buying shares at a discount.

It's a great time to talk about buybacks. We're in never-before-seen territory...

For the first time ever, U.S. share-buyback announcements topped $1 trillion last year...

And we're currently on track for more than $1 trillion in buybacks again this year.

On last week's Stansberry Investor Hour podcast, I mentioned Macy's as an extreme – yet informative – case study showing how share buybacks can become a disaster.

Every penny Macy's has spent on share buybacks since 2000 has gone up in smoke. The expenditures didn't benefit a single current shareholder.

For example, Macy's spent a total of $5.8 billion on share buybacks in 2006 and 2007.

According to data compiled from market-research firm FactSet, the company's stock peaked in March 2007 at $45.05 per share. It closed at a financial-crisis low of $7.42 in November 2008 – a drop of roughly 85%.

In other words, the company bought back nearly $6 billion in shares as its stock marched higher throughout 2006 and 2007.

So throughout 2008, with the stock trading at a price lower than any time since 1992, you might think Macy's would've been salivating at the prospect of creating massive value through buybacks.

You would be wrong.

Macy's suspended its share-buyback program in 2008 and didn't restart it until 2011. After the company started buying back stock again, it kept buying back more and more shares as the price climbed higher...

The so-called "retail apocalypse" kicked into full gear in 2015. As a result, Macy's stock price fell nearly in half that year – from more than $65 per share to less than $35 per share.

The market had clearly figured out that Macy's was in trouble, but the company kept buying its shares back... It bought more than $7.6 billion worth of shares from 2011 until it again suspended the practice in early 2017. And as it became clear that online-retail juggernaut Amazon (AMZN) was permanently impairing the earnings power of mall-based retailers like Macy's, the company's stock fell into the $20s... then into the $10s.

From 2000 to the present, Macy's board of directors has authorized a total of $18 billion in share buybacks. The company has used $16.3 billion for this purpose, leaving $1.7 billion unspent, as of its latest filings with the U.S. Securities and Exchange Commission.

Meanwhile, the company's market cap peaked in July 2015 at around $23 billion. Today, it's around $5 billion. That's an $18 billion drop in market value over the past four years.

Coincidentally, it's the exact amount the company's board set aside for share buybacks over the past two decades.

It's pure poetry that these two numbers match...

Like I said, it's just a coincidence. But it provides a perfect example of how share buybacks can't create lasting value for shareholders...

If a company's business is declining and its share price is falling right along with it, share buybacks will only add to the damage done as the management team throws money away.

Maybe you're thinking, "Dan, Macy's had no idea the retail industry was in trouble when the company bought back its stock. It's not their fault the stock tanked."

That doesn't sound right to me... If it isn't the fault of management that the business destroyed $18 billion in shareholder value over the past two decades, then whose fault is it?

The excuse for a company to implement share buybacks instead of using all its available cash to reward shareholders through dividend payments is usually the avoidance of "double taxation" – once at the corporate level and again at the individual shareholder level.

That's a good idea. Double taxation is an abomination... one of many we tolerate to live in a wonderful place like the U.S. But as the Macy's example shows, it only goes so far.

If Macy's instead had paid all $16.3 billion out in cash dividends, the net benefit to long-term shareholders would have been a lot higher than what they got from the share buybacks.

Macy's shareholders got $16.3 billion less in pretax proceeds out of the business than they could have.

Sure, I know many existing stockholders sold into the share repurchases. But anybody who held on to Macy's shares over the long term – trying to benefit from the buybacks – got crushed.

It makes me wonder if companies in certain industries should ever buy back shares...

Consider highly cyclical sectors – like mining, for example.

Should a metals miner that might not generate free cash flow for years ever spend money buying back its shares? We all know the stock will tank in the next cyclical downturn... So does it make sense to spend a fortune buying it back at any time other than a cyclical trough?

If there's cash to be extracted from the business, isn't a cash dividend payment the only way to make sure the benefit to the shareholder isn't erased by the stock market? If management buys back its shares near the stock's peak (I promise Macy's is just one of many examples), where will the value created by those buybacks be in the next downturn?

The answer is simple... Nowhere.

That brings me to FactSet's data on the top share repurchasers of the past 12 months...

I know a year is a relatively short span for long-term investors. But I can't help noticing that the big share repurchasers as a group didn't even generate a market-beating return...

The 10 companies in the benchmark S&P 500 Index that have bought back the most stock over the past year have produced an average total trailing 12-month return of 11%. That's significantly below the S&P 500's 16% rise over the past year.

Some companies are run by brilliant capital allocators...

But they can get share repurchases wrong, too. If you give even the greatest investor in the world an inch, there's a real risk he'll take a mile... just like anyone else.

I'm talking about Buffett, who still serves as chairman and CEO of Berkshire Hathaway (BRK-B). If any other corporate manager did what Buffett has done involving share repurchases at the company he founded, his actions would be met with suspicion.

Buffett initiated buybacks of Berkshire Hathaway's stock in September 2011...

In his February 2012 letter to shareholders, Buffett said the company would only buy shares back when they traded for 110% of book value or less (1.1 times book value). That sense of price discipline is exactly what you'd expect from the world's most famous value investor.

But then, in December 2012, he raised the criterion to 120% of book value. OK, no big deal. Maybe the previous limit was too conservative. We'd expect that from Buffett. No worries.

However, in July 2018, Buffett and his partner, Charlie Munger, did away with objective price limits for buybacks. I found the language in the 2018 annual report very interesting...

On July 17, 2018, Berkshire's Board of Directors authorized an amendment to the [share buyback] program, permitting Berkshire to repurchase shares any time that Warren Buffett, Berkshire's Chairman of the Board and Chief Executive Officer, and Charles Munger, Vice Chairman of the Board, believe that the repurchase price is below Berkshire's intrinsic value, conservatively determined.

In other words, instead of trusting an objective benchmark like 120% of book value, now we'll just have to trust that whatever Warren and Charlie decide is right for shareholders.

According to FactSet data, Berkshire Hathaway's stock has rarely traded below 1.2 times book value over the past decade. And it hasn't traded below that level at all since December 2012, when Buffett adjusted the criterion for buybacks from 1.1 to 1.2 times book value.

But as I said, Buffett believes in share buybacks. He has touted them for years. He has said as long as you get the stock below intrinsic value, it's the best way to spend excess cash.

I've seen this phenomenon before...

You love a stock. You want to keep buying. But its price goes out of a range you previously determined was cheap enough to produce a good return. So you cheat and pay too much.

In Berkshire's case, I actually doubt that Buffett and Munger are cheating too badly... if at all. I doubt that they're paying too much more than the intrinsic value of Berkshire's shares.

But the bottom line is that asking us to trust them at the precise moment they abandon objective pricing criteria is a big ask.

It would be standard operating procedure coming from almost any other company in the world. But it's a bit surprising when it's coming from two men who've repeatedly offered themselves as examples of disciplined capital allocation that others ought to follow.

The tendency to ask for an inch today and a mile tomorrow is just human nature...

That's the point I was making about 2020 Democratic presidential candidate Elizabeth Warren's wealth tax proposal in Friday's Digest.

Let Warren do it once, and she – and subsequent administrations – will do it again and again. They'll constantly expand the tax until it includes every asset you own, regardless of the size of your wealth. It'll go from just affecting billionaires to almost everyone in the U.S.

Likewise, if shareholders let a company buy back its shares whenever it wants, it'll buy them back hand over fist at market tops and never buy a single one anywhere near the market's inevitable bottoms.

In other words, the company will fail miserably to buy back its shares when the move has any chance of actually doing real, long-term good for the company's shareholders.

Perhaps instead of advocating for more share buybacks, activist investors should encourage better capital allocation. That includes putting more cash straight into shareholders' pockets through dividends when the company's management can't find anything to do with it.

Taxes or not, dividends have the slam-dunk aspect of not being erasable by the stock market and not leaving the investor exposed to the vagaries of the market.

Nobody wants to hear this kind of message right now with stocks continuing to hit all-time highs. But I bet it starts to sound like sweet music when the S&P 500 is down 30% or so.

The ugliest part of this entire situation isn't the destruction of shareholder value...

As companies light money on fire by buying back their stocks, a privileged few are making millions – even if the stock eventually tanks.

In April, I interviewed asset manager Ben Hunt on the Stansberry Investor Hour podcast.

He's a very insightful guy. And in a recent series of Twitter posts, Ben showed how the management team of video-game maker Electronic Arts (EA) used buybacks to sell shares worth millions of dollars. As he wrote on Twitter last Thursday...

Over the past [three fiscal years], Electronic Arts bought back 22.8 million shares for $2.3 billion... Also over the past [three fiscal years], Electronic Arts issued 10.7 million new shares to themselves for $211 million. About 1.5 million shares went to [Employee Stock Option Plan], rest to management.

Sarcastically echoing my own sentiment above, Hunt finds it "so weird that Electronic Arts uses share buybacks to 'return capital to shareholders' but has never paid a dividend."

Hunt finished up by pointing out that Electronic Arts CEO Andrew Wilson exercised stock options and sold 30,000 shares of stock for more than $3 million in proceeds back in March... five days after announcing that the company would lay off 350 employees.

This won't have much impact on Electronic Arts' stock in the short term. But in the long term, shareholders looking to compound their money could suffer from the move.

Last week, in a Financial Times opinion piece on the topic (subscription required), Hunt outed technology giant Microsoft (MSFT) for the same offense...

Microsoft spent $16.8 billion buying back 150 million shares in its most recent fiscal year, claiming it "returned capital to shareholders." But the company also issued 116 million shares as employees exercised stock options and sold restricted stock units.

Roughly 70% of the nearly $17 billion in Microsoft's buybacks went to managers who received options and restricted stock grants. Only 30% went to the company's purported goal of returning capital to shareholders who actually bought the stock in the open market.

Another recent Financial Times article showed data on share repurchases and stock compensation for several large companies in the third quarter of 2019...

Technology giant Alphabet (GOOGL) bought back $11 billion and issued $10.4 billion in stock compensation, effectively negating all but $600 million of its multibillion-dollar buyback program. Social media pioneer Facebook (FB) bought back $9.5 billion but issued $4.5 billion in stock compensation. Those aren't option exercises or restricted stock sales, but we all know they will be one day.

As an investor, you must ask yourself how much you care about this sort of thing...

Most companies will be on the not-so-good-looking side of it. Most companies will paper up their C-suites with options.

Most companies will opt for share buybacks over putting cash in your pocket with dividends because it creates demand for the shares... helping to support the stock price as the top executives cash out. And most companies will be lousy at buying back shares, doing it often at market tops and hardly at all at market bottoms.

If you hate all this incompetence and the semi-ethical activity around buybacks enough that you never want to buy a company doing it, you'll remove most stocks from consideration.

I'm sure you can find several examples of companies that bought back shares and created tremendous returns for investors. I'm not saying it can't be done... Consulting firm Fortuna Advisors cites defense contractor Northrop Grumman (NOC), drugmaker Allergan (AGN), and package-delivery giant FedEx (FDX) as companies that have tended to buy low.

But it's a bad idea to expect that type of smart management on a regular basis.

The way most companies implement share repurchases, it's less about creating shareholder value... and more like a combination of a cash-compensation expense and a tax that everyday investors must simply tolerate.

New 52-week highs (as of 11/22/19): DocuSign (DOCU), JPMorgan Chase (JPM), NetEase (NTES), and Flutter Entertainment (PDYPY).

In today's mailbag, we share feedback on Dan's Friday Digest about the financial media, taxes, and Elizabeth Warren... Have a comment or question? Send it our way at feedback@stansberryresearch.com.

"Dan, Great article! I couldn't agree more! Your writing is always a 'full course dinner' with everything to satisfy a hungry appetite for common sense and reason in this upside down world we currently live in. I appreciate it!" – Paid-up subscriber Paul E.

"Excellent essay about Warren and the politicos. And a good trip down the memory lane about taxes." – Paid-up subscriber Fabian H.

"Mr. Ferris, Do you not subscribe to Barron's daily email? Every day their email headline is: Dow moves UP/DOWN X-number-of-points because [whatever]. EVERY DAY. I, for one, think it's just habit for them.

"Some days it's obvious why the market moved. E.g. The Fed hikes/lowers interest rates (especially if it was a surprise). Some days there's some reasonable reason – and I use that term in its original meaning, 'something that can be reasoned with.' Some days, yeah, the reason they give is obviously tongue-in-cheek. Some days I'd like to see the message 'Dow finishes day unchanged because everybody was asleep.'

"Some people need someone to tell them why stuff happens, especially when it has to do with their money. The rest of us can look at a Barron's email headline for its entertainment value, nothing more." – Paid-up subscriber David B.

"Gee Dan, Are you really old enough to remember Gasoline Alley? I haven't heard a reference to Skeezix in 20 years! Thanks for the memory!" – Paid-up subscriber Sam O.

Good investing,

Dan Ferris
Vancouver, Washington
November 25, 2019