Wednesday, August 24, 2016

Stock Buybacks - A Sign of Liquidation? Yes - If 'Net Profit Test' Shows It

IN a previous post (Aug. 19)  I warned that one of the pitfalls of owning stocks was that numerous companies now use stock buybacks to inflate their share prices and this is almost certainly a sign of liquidation. If you knew would you really really want to invest in a company or corporation undergoing liquidation? 

I had written that a recent NY Times piece ('The Buyback Illusion.', Aug. 14, Business, p. 1) noted stock buybacks are more often "a way for executives to make a company's earnings per share look better because the purchases reduce the amount of stock it has outstanding"  Also, "when per share earnings are a sizable component of executive pay the motivation to do buybacks only increases."  The problem is that ultimately this game amounts to a "liquidation program".

Not mentioned in that blog post, but also in the Times article, is that a test exists by which investors can ascertain whether companies are resorting to buybacks and "self liquidating".  This "net profit test", according to Gary Lutin - a former investment banker who heads the Shareholder Forum:

"The test cuts through to the essential logic of comparing a process that grows a bigger pie - reinvestment - to a process that divides a shrunken pie among fewer people: share  buybacks"


"It's pretty obvious that even mediocre returns from reinvesting in the production of goods and services will beat what's effectively a liquidation plan."

This negative view of buybacks or "repurchases" is underscored by Robert L. Colby a retired investment professional and developer of Coequity, an equity valuation service. According to Colby (ibid.):

"The simplest way to evaluate a company's asset allocation decisions over the years is to see whether its net profit growth is close to its earnings per share growth."


"Unlike an investment in the business share buybacks have no effect on net profit and there is no compounding in future years."

These points were made nearly two decades ago by William Wolman and Anne Colamosca in their 1997 work, 'The Judas Economy: The Triumph of Capital And The Betrayal of Work'. They rigorously emphasized that would-be 401k mutual fund investors look at a company's actual earnings and not just the share price per se.

Let's say company XYX shows earnings per share over eight quarters increasing at the rate of 1 percent per quarter. This translates to 8 percent earnings per share growth over 2 years while its net profit growth over the same period is 7.8%.  Not exactly the same but close. . The company is also sound enough to be able to pay dividends.

Consider also company ZZZ, whose earning per share growth is computed to be (-0.1%) per quarter over the same time period. Over two years this marks a loss of -0.8% but its net profit growth is actually -4%. The company is in trouble, its net profit growth is out of whack with its earnings per share growth. In an effort to right the ship the company uses stock buybacks which artificially inflate the price of its shares - say from $10 each to $11.50 but only because a proportionate amount of shares have been taken out of circulation via the buybacks.

Ten million shares of ZZZ initially have a market capitalization of $10 x 10,000,000 = $100 m. But after buying back nearly 200,000 shares the share value is jacked up to $11.50.  What's going on? According to Messrs. Colby and Lutin ZZZ is liquidating.

Let's take specific examples from the article. It turns out Mr. Colby actually ran his net profit test for pairs of companies in the same industries from 2008 through 2015. In each case, he contrasted a company that "bought back loads of shares" with one that did not.  One specific pair entailed two restaurant chains, Cracker Barrel and Jack in the Box.

Cracker Barrel bought back $160m worth of shares over the period while Jack in the Box bought back $1.2 billion worth. This buyback reduced its share count by 37 percent. It saw an earnings per share increase of 6 percent over the period (7 years) but its net profit declined by 0.5 percent per year. In other words a loss of (-0.5 %/yr) x 7 yrs. = -3.5 %   By contrast, Cracker Barrel earning per share growth was 13. 6 percent while its net profits grew by approximately 14 percent. So it passed the test.

Target and Costco were also compared in a similar paired analysis. Costco spent $2.8 b to repurchase shares over the period while Target spent $11.4 b thereby reducing its share count by 20 percent (in effect liquidating a fraction). Costco's annual earnings per share gains were 9 percent over the period almost identical to its 8.9 percent net profit growth. By contrast Target's earnings per share rose by 7.3 percent while the net profit growth was only 4.3 percent.

The buyback craze, make no mistake is one big reason for the comparatively low levels of business investment since companies emerged from the 2008 financial crisis. This is also likely tied to the anemic annual growth rates if so many companies are doing it.   As noted at the end of the piece:

"Investors may be dazzled by the earnings per share gains that buybacks can achieve but who really wants to own a company in the process of liquidating itself?"

Good question!

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