Carl Icahn recently spoke at the Reuters Global Investment Outlook Summit. The activist investor suggested that share buybacks hide the poor performance of badly run companies. He stated: “Very simplistically put, a lot of the earnings are a mirage … They are not coming because the companies are well run but because of low interest rates.”
Interestingly, despite his stance on buybacks, he’s pushing Apple (AAPL) to repurchase $150 billion of its stock. Nonetheless, his point about share repurchases is accurate — they are a poor proxy for operational excellence. Eric Reguly goes further in an excellent Globe and Mail article from October, suggesting share repurchases destroy innovation.
Share repurchases aren’t all they’re cracked up to be. Here are a few examples illustrating why.
From 2001 to 2012, Intel (INTC) spent $67.7 billion repurchasing its shares, just $2.5 billion less than it did on research and development. Now, it’s true that some tech firms can go overboard on R&D, but INTC is hardly the poster child for overspending on research.
Share repurchases are a different matter altogether. In 2002, INTC posted diluted earnings per share of 19 cents. In 2012, that number jumped to $2.13 per share — a compound annual growth rate of 22.3%. That’s an excellent growth rate over such a long period. However, if you use net income rather than EPS, the figure drops to 19.6% — 270 basis points less per annum.
That might not seem like much, but if you invested the $67.7 billion spent on share repurchases at 2.7% (the difference) for 12 years you’d have an additional $25.5 billion or $3.70 per share at 2001’s share count of 6.9 billion. Furthermore, if you paid this out as a special dividend today, it amounts to a 14.9% yield. What’s not to like about those numbers?
In the twelve years between 2001 and 2012, the average company in the S&P 500 bought back $600 million of its stock annually for a grand total of $3.5 trillion, according to Professor William Lazonick, an economist at the University of Massachusetts Lowell. Buybacks peaked in 2007, the year before the market crash.
IBM (IBM), for example, repurchased $18.8 billion of its stock in 2007 — more than it repurchased in the two previous years combined. Paying an average of $105.39 per share for those shares, its annualized return on investment in the six years since is 10%, 430 basis points better than the SPDR S&P 500 (SPY).
But the problem is that most companies are terrible at timing buybacks, and unskilled at properly valuing themselves.
Consider the missed opportunity for IBM: Between 2007 and 2008, the company repurchased 268.3 million shares. If IBM had invested the $18.8 billion from 2007 along with $10.6 billion it used for repurchases in 2008 to buy shares at its low of $71.90 in October 2008, it could have acquired a whopping 408.9 million.
It’s All About Book Value
The Wall Street Journal reported in March that Exxon Mobil (XOM) repurchased $207 billion of its stock between 2003 and 2012. The article comes to the conclusion that XOM would have been far better off spending the money acquiring additional production rather than its stock.
To make matters worse, when it did make an acquisition, it drastically overpaid for XTO Energy, buying the natural gas producer for $40 billion in June 2010.
Forget that XOM overpaid for XTO for a moment and consider that when the stock hit $95 in 2007, the company repurchased $31.8 billion of its stock that year at an average cost of $82.38 per share. At the end of 2007, its book value per share (adding back $31.8 billion to book and 386 million shares to those outstanding) was $26.62 — meaning XOM paid 3.1 times book value for its shares.
Today XOM is trading around 2.5 times book value. Perhaps that’s the reason Berkshire Hathaway (BRK.B) acquired 40.1 million shares of the world’s largest oil company between July and the end of September. Interestingly, while Buffett is willing to pay 2.5 times book for XOM, he’s set a cap of 1.2 times book for his own stock. He knows it’s better to improve the business through acquisitions and capital expenditures than by gobbling up BRK.B stock.
Warren Buffett is definitely an enigma. He doesn’t always do what you think he’s going to do. But on share repurchases he’s crystal clear — he will not overpay for his company’s stock. So, why do others?
Well, for one, the executives of Intel, IBM and Exxon Mobil aren’t as smart as Warren Buffett; secondly, and more to the point, they do it because it makes them rich. It’s not hard to understand, but that doesn’t make it right.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.