Gustavo Ballvé on November 23rd, 2011
Corporate Governance, Corporate Strategy, Food for thought, Home, Investment Themes, Portfolio Management

Share buybacks have an “aura” of shareholder-friendliness. When done right, it’s a very efficient way of rewarding long-term shareholders and reaffirming management’s confidence in the company’s future prospects, usually after the shares have gone down. However, companies can get it wrong and sometimes very much so. A recent article in the New York Times reminded us of a few ways share buybacks can go wrong, and we highlight them inside. Important: Just as M&A now has a bad fame because it’s been overused and can be poorly thought and carried out, it would be wrong to automatically think the same of share buybacks. It can be used well and poorly, just as any other tool in managers’ toolkits.

The NYT article, in fact, doesn’t represent our view of the problem, since it mainly reflects the writer’s political opinion that a company shouldn’t be laying off so many employees if it has so much cash in the bank to do sizable share buybacks. That misses the point by a long shot.

There are two big points here. One is whether over-cautious companies are passing real opportunities to invest and hire at at time of supposedly cheap opportunities to do so. To put it another way: if companies were well managed (or got lucky, it doesn’t matter) enough to put away some cash and now see their less-efficient or troubled competitors suffer as well, isn’t this the time to invest and pull even more ahead when the cycle reverts?

The other point is: Inverting the reasoning above, let’s assume that the situation is so complicated that caution is indeed warranted. Shouldn’t keeping the cash as reserves be the real choice in this case?

Share buybacks are great when the shares are undervalued and there’s both clear visibility and a lack of better options – but we’re with Buffett in that they are just one of the many options for the shrewd capital allocator. It implies a level of visibility of long-term prospects and, well, sapience from management that’s seldom seen: management has to know that its company’s stock is cheap. As our 23-year experience picking stocks has shown, that kind of “certainty” (let’s call it asymmetrically favorable probability distributions) is hard to come by.

The real problem in this case is whether misaligned incentives/ conflicts of interest and the institutional imperative aren’t driving managers to do share buybacks – instead of motivation by sound financial and strategic reasons.

Conflicts of interest: That’s a risk when EPS is a big KPI (key performance indicator) in executives’ compensation plans. While it looks great on paper to drive alignment, there can be many situations in which this metric (if overweighted) can drive irrational or reckless behavior compared to long-term objectives. Cases of management driving repurchases to hit the EPS “sweet spot” for their compensation schemes are not unheard of, and that cash could have been used for investments or as a reserve against risky times.

Institutional Imperative: That’s a risk because share buybacks have an uncontested aura of shareholder-friendliness. To put it another way, CEOs don’t lose jobs for recommending share buybacks and less-inquisitive investors have also come to believe that a buyback program is always a good sign. Ask WorldCom shareholders whether Bernie Ebbers’ buybacks were a good idea – or, more recently, ask Netflix owners… In fact, there are even rough studies claiming that, in aggregate, share buybacks destroy value. Of course “in aggregate” means very little, and it reminds us of the studies that “show” that M&A destroys value. And just as M&A now has a bad fame because it’s been overused and can be poorly thought and carried out depending on the incentives and personalities of the management teams involved, we wouldn’t like share buybacks to be thought of a “bad move” per se. Both can be misused, just as any other tool in managers’ toolkits can.

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