Apple (AAPL) might not be making any innovative products these days, but it sure is good at stock buybacks. According to Bloomberg with help from Standard & Poor’s, AAPL’s buybacks over the past two years have achieved the best four-month returns among the 20 largest quarterly repurchases since 1998.
Portfolio Manager Todd Lowenstein of Highmark Capital Management says this about Apple’s buybacks: “Their timing was impeccable. They went in big, and it said to the market that they had confidence in their business plan and thought their stock was grossly undervalued. That’s worked out well for them.”
It has worked out well for Highmark, too — the company has been a shareholder since well before Apple’s recent handiwork. It’s only right then for Lowenstein to give props to the company that’s made Highmark look smart.
But before we anoint Tim Cook champion, let’s consider for a moment the two lies perpetuated by buybacks that fog investors’ rose-colored glasses.
The First Lie of Buybacks
The premise that buybacks boost earnings is a big fat lie. It’s an optical illusion meant to distract investors from the truth: Bottom-line growth is measured by net income only and not earnings per share. After all you wouldn’t judge top-line growth by anything other than revenue, would you?
A common argument for buybacks is that they lower share count while increasing earnings per share, thereby adding value for every remaining shareholder. In other words, you own a slightly bigger piece of the pie.
Let’s say that you own 10% of ABC Company’s 1.2 million shares outstanding. If ABC’s annual earnings are $1.2 million, its earnings would be $1 per share. Let’s suppose that ABC repurchases 200,000 shares of its stock. That would give you an additional 2 percentage points of ownership (a bigger piece of the pie) without investing another dollar.
Who wouldn’t want that?
It’s akin to buying a $300,000 house with $75,000 down and a $225,000 mortgage and then watching home prices double over the next five years. The equity in your house magically goes from 25% (75,000/300,000) to 63% (375,000/600,000) without making a single improvement. Stock buybacks operate in much the same manner because they mask what’s really going on with the business.
For a real-world example let’s look at Exxon Mobil (XOM)…
Between 2004 and 2008 XOM reduced its share count by 22% to 5.2 billion shares. In that period, earnings per share increased 169%. Yet, its actual earnings increased by only 110%.
Let’s compare this with the last five years.
XOM reduced its share count between 2009 and 2013 by 14% to 4.4 billion shares. Earnings per share decreased 15% while actual earnings lost 28%. So, when earnings are good, buybacks make EPS look better than they really are and when they’re bad, buybacks make them seem not nearly as awful.
Exxon Mobil spent $90 billion on buybacks in the past five years at a time when its business was taking a big step backwards in terms of earnings. If it had simply bought the SPDR S&P 500 (SPY) instead of its own stock its returns would have been close to 200% higher.
Meanwhile, the $90 billion did nothing for its actual business. It could have bought Tesla (TSLA) many times over with plenty to spare. Scoff if you will but that would have been original thinking, something Big Oil’s completely incapable of.
Companies like XOM perpetuate the lie that buybacks boost earnings, and investors keep eating it up.
The Second Lie of Buybacks
The second lie of buybacks is more deception than anything because they artificially lower the P/E ratio, which is the valuation metric many investors use to make buying decisions.
Using the example of ABC Company from above, let me explain.
Let’s assume that ABC was trading at $10 before it repurchased 200,000 of its shares. Its market cap would be $12 million (1.2 million shares times $10 per share) with a P/E ratio of 10 ($10 share price/$1 EPS). After the buybacks, its EPS would increase from $1 to $1.20 while its P/E would drop to 8.3, a decrease of 17% despite no change in earnings.
Then if the share price dropped by 20% to $8, its P/E ratio would drop to 6.7, creating a value trap where investors mistakingly assume the drop in multiple is a buying opportunity when in fact it’s nothing more than an optical illusion, especially when share prices are falling.
In our real-world example, XOM stock closed trading December 31, 2013, at $99.81. It’s 2013 diluted earnings per share were $7.37, which translates into a price-to-earnings ratio of 13.5. Add back the 730 million shares from buybacks made since the beginning of 2008 and then divide the revised share count of 5.2 billion into $32.6 billion, its 2013 net income, and you get a revised P/E of 15.8 — 17% higher.
Again, nothing has changed, but the valuation has gotten that much more expensive.
Tied in with this second lie is another financial metric used by investors: return on equity. Although net income is the numerator here instead of EPS, the reduction in shareholder equity caused by buybacks has the effect of boosting ROE despite absolutely nothing changing on the bottom line. It’s important for investors to be wary of this.
Ultimately, investors falling for these two lies could decide to buy Exxon Mobil stock based on nothing more than misinformation. Regardless of your feelings about a particular stock that’s never a good way to invest.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.