- I’ll explain how buybacks destroy your value.
- It’s important not to own GE-like companies going into the next economic downturn, which is nearing.
- $517 billion per year could be invested much better.
If there is something I am against, it’s buybacks that are made at any price. Would you pay $3.5 million for a house when the building cost plus the land cost just $1 million? Probably not, but that is exactly what corporate managers do on a daily basis while they keep telling you how good of a thing they are doing. Buybacks might seem like a good idea, but it destroys your value in the long term. Let me explain what’s going on.
One of the companies that has been doing the most buybacks is General Electric (NYSE: GE), and I wrote about it long before the current stock price and business meltdown happened. You can read more about GE here.
Now, it’s extremely important to be cautious and watch for what has happened to GE with other blue chip stocks that you might own. One of the big negative catalysts for stock price drops like GE’s are buybacks.
The problem with buybacks is that at first it looks like the company is doing a good thing as it lowers the number of shares outstanding, distributes money to shareholders, and you don’t have to pay a dividend tax on it. The problem is that such activity increases the demand for the stocks and pushes its stock price higher which isn’t a bad thing, right? Well that depends. If you are like most investors, you are buying stocks for your retirement month by month, so the higher the stock price is of a stock, the less you get for your money.
Over the long term, you end up with far less while the management gets more stock options thanks to the higher stock price. Further, the management usually overpays for the stock, and the more the stock costs, the more managers like to overpay.
The current price to book value of the S&P 500 is 3.53.
This means that the average S&P 500 company is paying $3.53 for something it can create internally for $1. Imagine where companies would be if all that money invested in buybacks was instead reinvested in the business.
In the last 12 months, S&P 500 companies have spent $517 billion on buybacks. That money invested in research or building new businesses would create much more value than buybacks. The problem is that corporations like to do buybacks when stocks are expensive, and not when they are cheap.
In 2009, buybacks were just a fraction of 2007 buybacks even though many stocks were 50% cheaper at the time.
Further, when doing a buyback, the seller of the stock gets the value. They are happy but they are not a shareholder of the company any longer. The remaining shareholders are there to hold the bag.
The problem is that by buying back stocks for more than what the actual book value is, the management destroys shareholder value. In the case of the S&P 500, $517 billion went out but the book value of the stocks bought was just $147 billion, thus $370 million went to happy no-longer shareholders.
This destroying of book value erodes the capacity the business has to survive downturns which happen all the time as we have seen with GE. If we take a look at the top three companies doing the most buybacks, you can see how their book value gets eroded while the stock price increases.
The problem with book value erosion is that there is nothing left to build on when the company stops growing or has lower earnings.
Apple (NASDAQ: AAPL) has had earnings of around $6 per share over the last 5 years, and has increased its book value for a total of just $5 in the last 5 years. Walgreens (NASDAQ: WBA) has increased its book value by a total of only $4 even though average earnings over the past 5 years have been $3. When the cycle turns for these companies, and eventually it will with negative earnings, I wouldn’t be surprised for their stock prices to fall to the respective book value.
Just consider what has happened to GE, which even with positive earnings has managed to lower its book value in the last 45 years.
So if a company buys back its own stock at a price to book value of 3.5, buying back 10% of the outstanding stock, it destroys 27% of its book value.
As we are in the late part of the economic cycle, a recession is near. Therefore, it’s extremely important to see what the value of a company will be with flat or negative earnings because growth will be limited in the future.
Don’t forget that corporations have been enjoying an 8-year economic expansion combined with extremely low interest rates. When the environment changes, there will be plenty of GEs.
Just a note, Berkshire will engage in share repurchases only when the price to book value is below 1.2. Should we listen and follow what Buffett does or follow the advice of 99% of the corporate management? Well, the answer has been pretty clear for the last 50 years. It will also be so for the next, mark my words.