Many investors like to buy shares in companies that are repurchasing their own shares. The idea is that as a company does this, it reduces the number of shares outstanding, so that each share owns a larger part of the company. However, this strategy has had mixed results. Often, companies buy back shares at the top of a cycle or in lieu of making other, more profitable investments. Companies may also buy back shares to conceal the fact that it is issuing shares to its executives: the issuance and the buyback cancel one another out so you don’t see it in the share count.
So, in what follows, I have pointed out four things that investors should look for when they are analyzing a company that returns capital to shareholders through share buybacks.
1. The company is reducing the number of shares outstanding
As I just mentioned, there are some companies that buy back stock in order to hide the fact that it is issuing stock to executives. Now it isn’t necessarily a bad thing when companies issue stock options to its executives. In many cases, these executives are extremely talented individuals who deserve to be compensated for their work. But there are some cases in which they use the corporation’s funds as their own. So one thing to look for in a buyback is that it works — that is, it reduces the number of shares outstanding meaningfully. Each quarter/year the company reports the average number of shares outstanding for that quarter/year. If the number goes down consistently and meaningfully, you have company that is rewarding long-term shareholders with buybacks.
2. The company “buys low” and “buys less high”
The best thing to look for in a company buying back stock is a company that buys back more heavily when the stock price falls and then slows down the pace, or even stops altogether when the stock rises. This shows prudence on the part of the management team, and it means that they have an understanding of the stock market. Too many companies simply buy back the same amount of stock every quarter. Now this is fine if the buyback is small. For instance, Chevron (NYSE:CVX) tends to do this, but its buyback is secondary to its dividend. A company that is aggressive in the market buying back stock needs to be tactful about it and take advantage of market volatility.
3. The company has a track record of buying back stock at lower prices
One think I like to look for is a company that trades at say $100/share that was buying back stock years ago at, say, $40/share or $50/share. This indicates to me that the buyback isn’t designed to generate short-term stock market pops. It is designed to generate value for long-term shareholders. It also gives me confidence in the inference that if management is buying back stock now, it means the stock is undervalued. After all, this logic has worked in the past.
4. The company pays a dividend
There is a logic to buying back stock over paying a dividend, namely the returns you get from dividends are taxed whereas the returns you get from buybacks are not. If you reinvest your dividend — which has already been taxed — then the dividend you earn on the dividend is taxed as well and you can see that we get to a point where some of your ownership in the company is taxed over and over again. If the company buys back stock, it makes the share price go up and you pay taxes 1 time on the capital gain. But despite this logic, a company that is returning capital to shareholders should be giving at least some of this capital to shareholders for them to decide what to do with it. A dividend is a different kind of capital return — it provides income for retirees and it lets investors know that management is confident in the long-term ability of the company to generate cash-flow.
While there are some instances where the above logic should be taken literally — for instance, if you own Berkshire Hathaway (NYSE:BRK.B) or another company that has a Buffett-like approach — I think the best approach is a mixed one.
Disclosure: Ben Kramer-Miller is long Chevron.