by Rohan Rangaraj | Research Analyst
One of the official Favorite Books in the Cove Street Capital Library is “The Outsiders” by William Thorndike, an in-depth study of eight of the last half-century’s greatest CEOs in terms of value creation. One trait they all shared was the propensity to go against conventional wisdom and buy back their company’s own stock when it was cheap.
The key here is cheap. We’ve noted on this blog before that many Boards and management teams don’t understand effective share repurchase, and with events of late we can’t help but revisit the topic. By now you’ve surely heard that everyone is buying back stock. Some say it’s great; others are worried because these buybacks coincide with a market near all-time highs. We would argue that both are correct, and point out that it depends entirely on the situation. For some reason, the discussion often seems to neglect the simple task of framing it properly: intelligent share repurchases can add tremendous value in the long run, while mindless, unintelligent repurchases with no regard for value can do just the opposite.
Recently, General Motors reached an agreement with a set of activist shareholders to spend $5 billion on share buybacks over the next two years. On the one hand, no shareholder is complaining about the near-term effect it had on GM’s stock. On the other hand, one can’t fault investors who express concern at the prospect of a company in an intensely cyclical industry having less cash to serve as a cushion when an inevitable downturn hits. From our standpoint, we think GM is cheap, that it will be purchasing its shares below intrinsic value, and it has plenty of cash to weather even something a little bit stronger than a garden variety recession.
On that note, we were irked to come across this drivel vomited out by no less than the Harvard Business Review. The money quote: “Taxpayers and workers should demand that open-market repurchases by all companies be banned.” Ugh. We didn’t know they were letting high school seniors write for HBR.
While we won’t dispute that a majority of repurchases are likely done for misguided reasons without any eye towards intrinsic value—like, say, buying back exactly enough to offset dilution every single year regardless of price—it’s sheer nonsense to discount the enormous advantage prudent buybacks can create for a company whose management uses them as an effective capital allocation lever over the long-term. Arguments suggesting that buybacks ignore the common worker are extraordinarily short-sighted—for instance, they ignore the glaring likelihood that a company trading under its intrinsic value for too long will more often than not be gobbled up by a larger competitor (or private equity buyer) who invariably proceeds to lay off half the company. So not only does intelligent share repurchase add tremendous value in the long run, it can also add tremendous stability for companies as well. We are optimistic that GM’s should do the same.
On that point, we would be remiss not to mention one buyback program of recent years that was at least somewhat off the mark—that of IBM. Warren Buffett, in his 2011 letter to shareholders, extolled IBM’s leverage-to-buyback strategy of the prior several years. He further expressed his hope that over the next five years, as the company plowed perhaps $50 billion into buybacks, the stock would languish so IBM could buy in more shares more cheaply, and as a result he’d own a greater proportional share of a wonderful business.
Hindsight is 20/20 of course, but unfortunately that letter top-ticked the stock. 3 years and $40 billion of buybacks later, it’s fair to question whether IBM would have been better served had they allocated some portion of those buybacks towards more aggressively building out the weaker areas of the business. Despite using massive buybacks to show continued increases in EPS in dogged pursuit of the prior CEO’s stated 2015 $20 EPS target, the stock indeed languished up until last fall, at which point it tumbled off a cliff as its relative underinvestment in cloud and data analytics finally caught up to it and IBM abandoned its pie-in-the-sky $20 goal.
This is not to knock Mr. Buffett for failing to forecast this (though several have argued it violated his “circle of competence” standard), but it brings up an important caveat when thinking about buybacks: is it better to be a larger shareholder of a declining business, or a smaller shareholder of a business which actually has solid prospects for the foreseeable future? Instead of buying back $40 billion of stock at an average price of $191—nearly 20% above today’s price—as IBM did over the past 3 years, it easily could have used its cash along with a slight amount of leverage and, as some analysts have suggested, purchased companies such as Salesforce.com or Workday. Just taking those as an example, the two would not have come cheaply—they’d have cost around $25-30 billion for $2.5 billion in sales (versus combined market caps today of $60 billion and sales of $6 billion, growing 36%)—but they would have immediately established IBM as an early-mover in precisely the area which it finds itself so far behind today: cloud services. Meanwhile, in part due to the company’s efforts coming so late, IBM is seeing such an acceleration of declines that one analyst notes they are “dwarfing IBM’s ability to capture new revenue opportunities as the market shifts.”
Now, investors (yours truly included) almost certainly would have slammed IBM for the lofty multiples it would’ve needed to pay to snap up those businesses. However—and here’s the rub—it’s not likely that it has been overwhelmingly cheap to attract the talent necessary to build out those systems internally. Additionally, it has taken much more time for them to attempt to build these capabilities internally, while the resulting organizational dysfunction has led to considerable reputational damage for IBM with its longstanding clients. Being an early mover can mean a lot more in this business than it does in, say, widget manufacturing. Further, given the near-existential threat these competitors have posed to IBM—something the company almost certainly must have suspected at the time—IBM may have been better off paying a fair premium to save the company.
In any event, the result of all this is that IBM has scaled back its buyback program to a decade-plus low after it finally abandoned its 2015 goal of $20 EPS. While the stock reacted swiftly and negatively to this retreat, we can’t help but think that the resulting freedom from the tether of using buybacks to hit that arbitrary-and-no-longer-relevant earnings target just might enable IBM to act more aggressively and someday regain its prior heights (opportunistic buybacks included, of course!).
In the meantime, there is no question IBM is facing a very real threat, one that may at least have been partially staved off by a different capital allocation strategy over the past several years. The larger point here is this: blind devotion to buybacks is not much better than blind disregard for them. Buyback decisions ought to be intelligent and opportunistic (i.e. based on intrinsic value), but should also remain in balance with the other capital needs of the business as an important part of generating outsized returns over the long-term.
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