Brian at Pinch that Penny asked me to write about share repurchases.
There are two issues here, whether or not a buyback artificially inflates the price of a security, and how a buyback should affect your investment in a particular company.
Let’s first talk about what a share repurchase agreement really is. Share repurchases happen when a company buys back its stock from the open market. Generally, companies repurchase their own shares to reduce the number of shares outstanding, and to pass earnings on to investors in the form of more valuable shares.
Think about it this way: a $100 million company with 10 million shares would have a share price of $10. The same $100 million company with 8 million shares outstanding would have per share price of $12.5. That is to say that if you own 1 share in a company with 8 million shares outstanding, you own 25% more of the company than if it had 10 million outstanding shares.
Artificial Price Surge
So the question is, will a share buyback create an artificial price surge? And the answer to this question is a very strong “maybe.”
You have to look at a share repurchase as a percentage of normal volume. If only 10,000 shares trade on a normal trading day, and a company wants to repurchase 5 million shares (500 times the average daily volume) you should expect a large price surge in the underlying stock. There’s a huge source of new demand for shares, yet the supply of shares remains constant – actually it shrinks as a share repurchase is rolled out.
Low Volume, Large Repurchase
In this case, a share repurchase has a huge influence on the market value of the security. I have an example in my own portfolio. I purchased shares of Wireless Telecom Group, Inc. (WTT) because the company, after subtracting cash on hand, was essentially free. I explained how this worked in an article about investing like the Pawn Stars. Net-net, I purchased shares in a profitable business for $.78 each, which gave me ownership of assets worth $1.13 in a company that would continue to produce profits well into the future.
You usually can’t lose when you buy companies for less than the cash in the cash register. Later, Wireless Telecom Group (WTT) repurchased just over 1 million shares, pushing the share price up more than 50%. Given that average volume was around 20,000 shares per day at the time, the price rose rapidly. I have since exited my position, since it does not offer the same margin of safety or discount to book value at the present time. I vented earlier about my frustrations with the company’s management in an article about activist investing.
Short-interest in a particular firm must also be considered by any investor. Heavy short-selling is often reversed when a repurchase agreement is announced. Assume a stock trades for $8 per share, and the company announces a repurchase of huge amounts of stock at any price under $10 per share. Short-sellers will naturally exit their positions, given the company is putting a price floor underneath the stock for the time being.
No one wants to hold a stock short at $8 per share when the company has every intention to keep the per share price at $10 or more. Short-sellers must buy to cover their existing short positions, and this influences the market price. Nasdaq.com reports the amount of short interest in a security as well as the days-to-cover ratio, or the number of days of average volume necessary for all short-sellers to buy to cover. When the days-to-cover ratio is higher than a full week or two of trading, know that the reversal of short positions can be a huge source of new share demand, which pushes the stock price even higher.
When you have short-sellers exiting their positions (and purchasing shares to do so) alongside a commitment from a firm to repurchase shares, upside potential is enormous, and frankly, often artificial. Short-sellers may exit the firm immediately, pushing the per-share price above $10 without any actual reduction in shares, since the company never follows through with its goal to repurchase shares below $10.
Real Price Surge
Artificial price surges behind us, we must also consider a real price surge. Share repurchases can and should give a real price surge due to the changing dynamics of a particular company.
We have to consider the cost of capital vs. the expected return of a particular company. Holding cash in a bank account makes a business less than 1% per year at best. However, many companies trade for free cash flow yield of 5-10% per year, which means for every $10 in market value, the company generates $.50-$1 of free cash flow to investors.
Why not instead use excess cash to repurchase shares in your own company? Certainly, a company should expect to generate a better return on its own stock than it would get in risk-free, short-term securities.
And why not leverage the company with debt to repurchase shares? If you can borrow money to repurchase shares at a 4% rate and expect your firm to generate 7-8% in free cash flow yield each year, why not leverage up for repurchases? Any time you can borrow at 4% and invest at 7-8% you do very, very well.
You just have to recognize, for yourself, whether or not a particular company is something you want to hold for the long haul. A share repurchase is essentially a forced purchase by shareholders of the company’s stock. If you don’t want to hold the company for 20 years, why would you want to hold a company repurchasing shares? If the company’s future cannot be predicted out 10-15 years, you probably don’t want anything to do with the company’s repurchase agreement.
You have to value the firm as a whole business. At what price is a company cheap, and at what price is it fairly valued or over-valued? Is $600 billion for Apple Inc. too expensive?
If so, sell your shares when the market cap reaches $600 billion, whatever share price that happens to be. Looking at any investment as a stock is a really bad idea. Look at the company as a business, and follow through accordingly.
If you purchased the business for the long haul, a share repurchase should excite you as the company is delivering higher returns on assets by moving poor-yielding cash into a higher yielding business. Alternatively, it may take out long-term debt at a low interest rate to repurchase shares with a higher expected return.
If you purchased the business for the short-term, and do not find a particular business worthy of holding at any price, the rising price of the business following a repurchase can be a great time to exit.
I had no qualms selling my WTT shares at an average price of ~ $1.20 per share, as it wasn’t something I really wanted to own for a very long time – I just didn’t see a future in the business. I saw instant cash, which was undervalued by the market. And I saw the potential to liquidate from the higher volume and per-share price encouraged by a share repurchase agreement.
Other companies in my portfolio would be my new favorites if said companies were to initiate a large share repurchase. As I expect free cash flow yield of 8-10% from Darling International in perpetuity, I would be ecstatic if the company borrowed at 4-6% to repurchase shares yielding 8-10%. Having a somewhat strong competitive advantage, I would love to hold it, even if it were leveraged to the hilt with outstanding debt. Once it pays off its acquisition debt, which has a higher interest rate, I remain convinced that shareholders will push the company to leverage again at a lower rate (due to the lower risk) to repurchase shares in the company. As I can see the company delivering consistent earnings for a very long time, repurchases would be excellent.
It’s all about predictability!
Companies do not buy back stock when the cost of capital (either the opportunity cost, or debt cost) is greater than the expected return in the company’s stock. However, it is very easy for CFOs to totally screw up the calculation, since they often forecast earnings or earnings growth far in excess of what is realistic. In this scenario, investors often get burned when companies pay 4% per year to repurchase shares they expect to grow at a 10% annual clip. If the company bids up the stock pushing down the implied return to 6% based on numbers that do not prove to be realistic – adios, bank account! That’s just wasted money.
Ideally, investors would want the executives to be realistic about growth, and get excited about share repurchases only when the business is very, very predictable. If I had any say in the deal, investors would only buy shares in companies that ARE predictable – but that’s another topic for another day.
Read more on repurchases: I analyzed an exchange-traded fund, the PowerShares BuyBack Achievers ETF in an article at ETFBase. For those who enjoy passive investments and share repurchases, this would be a good fund to think about adding to your portfolio.