Evaluating Share Repurchases: Advice From Benjamin Graham
Benjamin Graham, often called the father of value investing, achieved his fame in a market and an economy that was in many was different from today's. However, much of his advice is still applicable to this day, including his thoughts on common stock share repurchase programs.
In "The Intelligent Investor," Graham wrote the following:
"When a company repurchases some of its stock, that reduces the number of its shares outstanding. Even if its net income stays flat, the company's earnings per share will rise, since its total earnings will be spread across fewer shares. That, in turn, should lift the stock price. Better yet, unlike a dividend, a buyback is tax-free to investors who don't sell their shares. Thus it increases the value of their stock without raising their tax bill. And if the shares are cheap, then spending spare cash to repurchase them is an excellent use of the company's capital.
All this is true in theory. Unfortunately, in the real world, stock buybacks have come to serve a purpose that can only be described as sinister. Now that grants of stock options have become such a large part of executive compensation, many companies--especially in hightech industries--must issue hundreds of millions of shares to give to the managers who exercise those stock options."
Reasons for repurchasing shares
These passages outline two main purposes for large-scale share repurchase programs. The first is to buy back shares when they are trading at low prices, perhaps due to lack of analyst coverage, temporary setbacks or undeserved market devaluation based around news events. In these cases, investors may be tempted to sell for prices that are lower than intrinsic value, which would be detrimental to the company. A share repurchase program meant to address this kind of problem is a good use of the company's money because it helps increase shareholder value for a bargain price during tough times.
In the second type of situation, a company might buy back shares when stocks are trading at high prices and the company is generating plenty of cash. This allows executives and other employees who have received company stock options as part of equity compensation plans to exercise their options at a beneficial price. When the options are exercised and create new stock, they can also reap the benefits of the price increases that result from the share repurchases. This is not a good use of the company's money, as it increases shareholder value at inflated prices during already-profitable times.
EBay
One example of a company that has recently bought back shares due to declining share prices is eBay Inc. (NASDAQ:EBAY). After the e-commerce giant's net income dropped into the negative range for full-year 2017, its shares plunged 43.4% from a high of $46.19 in February of 2018 to a low of $26.14 in December that year.
The net loss was mostly due to a $3.1 billion tax bill from the enactment of the Tax Cuts and Jobs Act. Such an extreme number obscured the fact that, according to Devin Wenig, the president and CEO of the company at the time, "Q4 was a record quarter for eBay, representing the fifth quarter in a row of volume acceleration in our US Marketplace." (As of Sept. 25, 2019, Scott Shenkel is the new CEO.)
According to GuruFocus data, eBay's share repurchase rate was 8.2% over the past three years and 15% over the past year. As of Jan. 21, it has a market cap of $28.94 billion, with 813.53 million shares outstanding.
The company's latest 10-Q filing for the third quarter of 2019 shows that its share count decreased from 983 million at the end of third-quarter 2018 to 837 million at the end of third-quarter 2019. Equity incentives exercised by members of the company during these periods were 9 million and 7 million, accounting for 0.9% and 0.8%, respectively. In total, the company spent $6 billion on share repurchases in 2018 and another $4 billion in 2019.
Bank of America
An example of a company that has recently bought back shares despite increasing prices is Bank of America Corp. (NYSE:BAC). The banking giant's largest loss since 2009 came in 2018, when its shares fell 17% compared to the S&P 500's loss of 6% amidst tentative fears that the market was entering a recession. It turned out to be a false alarm; Bank of America's share prices soon recovered, and its net income kept growing.
Due to their nature, big banks are difficult to compare to other business, as their success depends far more on the overall economy than most industries. However, in the chart above, you can see that when the U.S. economy entered a recession after the tech bubble burst, Bank of America's earnings remained constant and it share price barely moved. The big banks were at the center of the 2008 financial crisis, so that was an entirely different animal.
According to GuruFocus data, Bank of America's share repurchase rate was 2.3% over the past three years and 6% over the past year. As of Jan. 21, it has a market cap of $304.85 billion, with 8.836 billion shares outstanding.
The bank's latest 10-Q filing was for the quarter ended on Sept. 30, 2019. According to the 10-Q, average common shares issued and outstanding decreased from 10.031 billion in the 2018 third quarter to 9.303 billion at the end of third-quarter 2019. During the same time period, "dilutive potential common shares" decreased from 139.2 million to 49.3 million, meaning that equity incentives for members of the company accounted for approximately 12.34% of share buybacks year over year. Bank of America spent approximately $23 billion on common stock repurchases between July 2018 and June 2019, after which it announced a $30.9 billion repurchase plan for July 2019 to June 2020.
Conclusion
There are countless factors that investors may consider when making decisions about whether to buy shares of a company. Some companies repurchase shares at low prices while others repurchase shares at high prices, but both cases produce higher share prices and earnings per share than otherwise would have been possible.
It can be argued that both examples merit a measure of caution. In cases like eBay, where the company repurchases shares after a price decline, it is important to evaluate its fundamentals and long-term growth endeavors. Graham recommends buying stocks cheap and buying more of a good business when the price falls, but it has to be a good business - if a cheap stock goes bankrupt, it's still a total loss. On the other hand, despite the fact that a much larger portion of Bank of America's share buybacks have gone toward benefitting members of the company, it is undeniable that an increase in share price benefits all shareholders. If you are confident that a company will continue increasing its share repurchases and revenues, it can still be a profitable investment. Just keep in mind that in terms of benefitting a company's fundamentals, it is better to repurchase shares at a lower cost.
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This article first appeared on GuruFocus.
