Corporate executives have two jobs: to operate their businesses efficiently, and to allocate capital effectively. That’s it. Within those two responsibilities, executives have six ways to use excess cash: working capital, capital expenditures, mergers and acquisitions, dividends, debt repayment and share repurchases.
These days it seems a majority of excess cash is used for share repurchases. According to Bloomberg, buybacks are at their highest levels in four years due to stock valuations that are cheaper today than before the credit crisis began. Shareholders might think this is good news, but it’s not. Share repurchases are an ineffective and wasteful use of funds.
Warren Buffett implemented a share repurchase program last September at Berkshire Hathaway (NYSE:BRK.B, BRK.A), which is ironic because he stated in his 1999 annual letter to shareholders that the repurchase of 2% of a company’s shares at a 25% discount to intrinsic value delivers 0.5% additional value. Translation: They’re virtually meaningless.
Special dividends would be so much more tangible to shareholders because it’s putting cash in their hands, yet there isn’t the same entitlement that comes with a regular dividend. Furthermore, it provides management with greater financial flexibility to do what’s best for the business at any given point in time.
Most importantly, research indicates that during the past decade, S&P 500 companies have bought back far more stock when share prices are at their highest than when they’re at their lowest. Considering S&P 500 companies bought back $403 billion in stock in the 12 months ended Sept. 30, 2011, compared to $350 billion in dividends in 2011 for the entire U.S. market, you know CEOs aren’t heeding the Oracle’s words.
Supporters of share buybacks might point to the PowerShares Buyback Achievers Portfolio (NYSE:PKW) as evidence that they do work. The performance of the Share Buyback Achievers Index — which consists of companies repurchasing at least 5% or more of its outstanding shares — has trounced the S&P 500 for the trailing 12 months. Its five-year annual return to the end of December 2011 is 2.13% compared to a loss of 0.25% for the S&P 500.
This seems to fly in the face of what I’ve already said. However, there’s an explanation.
If you look more closely at the fund’s holdings, you will see that 31% is invested in consumer discretionary companies. In the past five years, the Select Sector Consumer Discretionary SPDR (NYSE:XLY) has achieved an annual return of 1.9%, only 23 basis points less. What this tells me is that the buyback fund likely would have achieved similar returns regardless of the share repurchases. In essence, buybacks are taking credit for the general success of consumer discretionary firms, and that’s clearly not the case.
Using one of the top holdings in the PowerShares Buyback Achievers Portfolio that has been in the news recently for share repurchase activities, I’m confident you’ll see the light when it comes to these nasty practices.
ConocoPhillips (NYSE:COP) is the No. 1 holding in the ETF at 5.08% of the fund’s assets. In early December, ConocoPhillips, which is splitting itself into two businesses, announced it was repurchasing $10 billion of its stock. That’s on top of the $15 billion it’s acquired in the past two years. Since 2008, COP has bought back 323.7 million shares at an average cost of $71.67 a share and a total expenditure of $23.2 billion. During the same four-year period, ConocoPhillips paid out $12.4 billion in dividends.
In that time, ConocoPhillips’ earnings per share have gone from $7.22 in 2007 to $8.97 in 2011. That’s a compound annual growth rate of 6.6%. That’s not bad until you take into account net income. On that basis, earnings increased at a rate of 1.5% annually. Approximately 77% of its annual EPS growth is due to share count reduction and not improvement in its business.
Furthermore, if ConocoPhillips didn’t make $23.2 billion in share repurchases and instead paid out four annual special dividends, shareholders would have achieved an annual total return of 8.3% — 540 basis points higher than COP’s actual return. In 2009, ConocoPhillips increased its quarterly dividend from 47 cents to 50 cents per share, a 6.4% increase. Despite paying 3 cents more in total dividends in 2009 — thanks to the share repurchases — it actually paid out $22 million less in total dollars.
Bottom line: ConocoPhillips is a decent company, but management clearly is not acting in the best interests of shareholders.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.