Buybacks are always a topic of hot debate. Once a rare occurrence, buybacks have surged to become a dominant method for companies to return capital to shareholders. In this post, we examine the intricacies of share buybacks, examining their mechanics, historical trends, motivations, and consequences.
Share buybacks have risen to prominence in the corporate world, significantly shaping how companies distribute their earnings. The practice involves a company repurchasing its own shares from the market, effectively reducing the number of outstanding shares. This tends to lead to an “improvement” in earnings per share (EPS) and makes comparable analysis challenging.
Nevertheless, this trend gained momentum in the 21st century, with S&P 500 companies alone buying back more than $800 billion worth of shares in 2018. Proponents argue that buybacks provide flexibility in capital management, while critics contend that they disproportionately benefit executives at the expense of the financial health of the company.
Mechanics of Share Repurchases
Share repurchases can be executed through various methods, each with its own implications:
Open-Market Repurchases (OMRs): The most common method, where companies buy back shares on the open market. It provides flexibility but lacks a firm commitment to repurchase.
Fixed-Price Tender Offers: Companies offer to buy back shares at a specific price, often at a premium, providing a strong signal of undervaluation.
Dutch Auction Tender Offers: Shareholders indicate the price they are willing to accept, and the company sets the final price based on these bids.
Privately Negotiated Repurchases: Buybacks from specific large shareholders, often at a negotiated price.
Accelerated Share Repurchases (ASRs): Immediate repurchase of shares from a financial intermediary, which then covers its position by buying shares in the market over time.
A good way to compare companies in terms of the amount of buybacks that they are doing is to look at the "buyback yield".
The buyback yield is calculated by dividing the total value of repurchased shares by the company's market capitalization.
Here are a few companies with a relatively high buyback yield. Big surprise, Apple does not top the list!
Historical Trends in Share Repurchases
The preference for share repurchases over dividends emerged prominently towards the end of the 20th century, driven by regulatory changes such as the adoption of SEC Rule 10b-18 in 1982.
This rule provided a "safe harbor" for companies, protecting them from accusations of market manipulation when conducting open-market buybacks. Since then, the value of share repurchases has grown substantially, often surpassing dividend payouts, especially during economic booms. However, repurchase activity tends to decrease during economic downturns, reflecting its pro-cyclical nature.
Over the last two decades, with interest rates at all-time lows, many companies have borrowed money to buy back shares, instead of using the debt for growth.
Motivations for Stock Buybacks
Companies repurchase shares for various reasons:
Stock Undervaluation: Many executives believe that their company's shares are undervalued and buy back stock to signal confidence in future performance.
Signaling: Buybacks can indicate management’s positive outlook on the company’s prospects, which is particularly credible if accompanied by other signals like insider buying.
Financial Flexibility: Repurchases offer a flexible way to return excess cash to shareholders without committing to regular dividend payments. Buybacks can be done sporadically, but dividends usually need to be consistent. Once a company commits to a dividend, cutting that dividend can send a very negative signal.
Excess Cash: Companies with surplus cash and limited investment opportunities often prefer buybacks as a means to return value to shareholders.
Employee Incentives: Buybacks can be used to manage dilution from stock options and enhance employee compensation tied to stock performance.
Consequences of Share Buybacks
The implications of share buybacks are multifaceted, impacting various aspects of corporate finance and market dynamics:
Impact on Share Prices and Returns
Short-term Gains: Announcements of buybacks generally lead to short-term increases in stock prices.
Long-term Performance: The long-term impact varies, with some studies showing positive abnormal returns and others indicating no significant effect.
Earnings Per Share (EPS) Improvement
Mechanical Increase: Buybacks reduce the number of outstanding shares, thus increasing EPS.
Managerial Incentives: Managers may be incentivized to use buybacks to meet EPS targets, especially if their compensation is linked to EPS.
Capital Structure and Financial Flexibility
Increased Leverage: Buybacks reduce cash reserves and can increase leverage, affecting the company's risk profile.
Reduced Flexibility: While buybacks offer payout flexibility, they can also reduce the company's financial cushion for future needs.
Signaling and Information Asymmetry
Positive Signals: Buybacks can signal undervaluation and management’s confidence.
Potential for Misleading Signals: If used to artificially boost stock prices, buybacks can mislead investors.
Corporate Investment and Growth
Investment Reduction: Funds used for buybacks are not available for capital expenditures, potentially limiting growth.
Life Cycle Considerations: Mature companies with fewer growth opportunities may prefer buybacks, while growth companies might prioritize reinvestment.
Impact on Shareholder Value
Enhanced Value: Properly executed buybacks can enhance shareholder value.
Agency Problems: Buybacks driven by executive self-interest may not align with shareholder interests.
Market Liquidity and Volatility
Mixed Effects on Liquidity: Buybacks can either reduce liquidity by increasing adverse selection costs or improve it by adding competition to market makers.
Volatility: Buybacks can stabilize prices in downturns but may also contribute to volatility.
Debtholder Wealth
Potential Wealth Transfer: Increased leverage from buybacks can impact debtholders, though evidence suggests mixed effects on debtholder wealth.
The Buyback Blackout Window
A buyback blackout window is a period during which a company is restricted from repurchasing its own shares, typically starting two weeks before the release of significant financial information like quarterly earnings reports and ending a few days afterward.
Mandated by regulatory bodies to prevent insider trading and ensure fair market practices, these windows help maintain market integrity and investor confidence by preventing companies from taking advantage of non-public information.
Companies may also implement their own, often stricter, policies regarding these blackout periods. Specific details about a company's buyback blackout window can usually be found in SEC filings, investor relations materials, or by contacting the company's investor relations department directly.
The Impact of Buyback Blackout Windows
There’s a common perception that buyback blackout windows can impact stock performance. While it is true that companies have to refrain from buying back shares during this window, a study done by Matthew J. Bartolini and Aram Kaplanian debunks this theory.
The white paper titled "Buyback Blackout Periods Do Not Negatively Impact Performance" investigates the theory that stock buyback blackout periods negatively affect market performance. This theory emerged prominently after the October 2018 market correction when the S&P 500 Index dropped significantly. The authors analyze historical data to test this theory, focusing on the relationship between stock buybacks and market returns. Their research examines periods before, during, and after earnings announcements, finding no significant negative impact on performance due to blackout periods.
The study concludes that the theory is unfounded, as there is no strong linkage between buybacks and market declines during blackout periods. Instead, the performance of firms with high buyback ratios remains mostly idiosyncratic and does not support the idea that buyback suspensions during these periods cause market selloff.
A Few More Complex Issues
SEC Rule 10b-18 provides a "safe harbor" for companies conducting stock repurchases, shielding them from liability for market manipulation under certain conditions regarding the manner, timing, price, and volume of repurchases. Compliance is voluntary but necessary to benefit from the safe harbor protection. (Source: Share Repurchases)
Key Exceptions and Conditions
Single Broker/Dealer: All repurchases on a given day must be conducted through a single broker or dealer.
Timing Restrictions
Companies with an average daily trading volume (ADTV) of less than $1 million or a public float below $150 million cannot repurchase shares during the last 30 minutes of trading.
Companies with higher ADTV or public float values can trade until the last 10 minutes of trading.
Other Considerations
Price Limitation: Repurchases must not exceed the highest independent bid or the last transaction price quoted.
Volume Limitation: Daily repurchases must not exceed 25% of the security’s ADTV, with an exception allowing for one block trade per week without adhering to the 25% limit.
Exceptions to Rule 10b-18's Safe Harbor
Off-Market Transactions: Privately negotiated repurchases, such as accelerated share repurchase plans or forward contracts, do not qualify for safe harbor protection.
Mergers and Acquisitions: The safe harbor does not apply from the public announcement of a merger or similar transaction until the completion of the transaction or shareholder vote.
Other Purchases: Purchases made as part of employee plans by independent agents, fractional security interest purchases, and repurchases of securities other than common stock are not covered.
Additionally, Rule 10b-18 does not protect against insider trading violations. Companies often implement blackout periods to avoid repurchasing shares while in possession of material nonpublic information.
Establishing a Rule 10b5-1 trading plan can help companies repurchase shares without facing insider trading allegations, provided the plan is set up when the company is not in possession of such information and complies with the rule's requirements.
Closing Thoughts
Buybacks are not always a bad thing. They often offer flexibility and potential value enhancement but also carry risks and consequences that must be carefully managed. Understanding the motivations and outcomes of buybacks is crucial for investors.
Companies that repurchase shares to look good, and meet management EPS targets should be viewed with some skepticism. Add to that, if these buybacks are not being done with excess cash but, are using borrowed funds or funds that should’ve been reinvested for growth, that is a definite red flag!