A record number of firms have been repurchasing their own shares off the public market in an attempt to utilize cash effectively. Companies bought back over $1 trillion of their own stock in 2018 with the new tax bill perpetuating this recent trend. Q1 of this year was no exception to that trend with 80% of S&P 500 firms reporting stock repurchases this past quarter, totaling $180 billion in value.
Companies leading this trend include tech giants like Apple (AAPL), Oracle (ORCL), and Cisco Systems (CSCO), as well as big banks like Wells Fargo (WFC), Bank of America (BAC) and JP Morgan (JPM).
Was this the most effective use of the economy's surge in corporate cash or had these firms just been buying up a record amount of their own stock because businesses only wanted to see stock price returns without the hassle of creating real value? I discuss the positives of this argument in Stock Buyback Frenzy: How This Will Effect You and then I went on to consider the negative side of the argument in Stock Buyback Frenzy: May Be Adverse to Long-Term Objectives. In this article, I will give a little bit of color on how effective I believe stock repurchases are for a firm and its stakeholders.
Stock Buybacks vs. Actively Traded Funds
Over the last year, all three of the US’s major indices hit multiple all-time highs with the US equity market rallying in one of the longest bull markets in US history. The question I pose to you as an investor is whether you believe that all-time highs would be an excellent opportunity to invest or a time to stay away?
There is no clear answer to this question because on one hand, stocks have never been selling at a higher price, and on the other, the rally could easily continue. When a company buys back its stock, it is indicating to the market that management believes their stock is undervalued. Unfortunately, it is practically impossible to call peaks and troughs in the markets nowadays even as an insider managing a business (unless manipulation is involved of course).
The market has a mind of its own as of late. This is why actively traded funds are a dying breed and investors focus more on passive ETF type funds where they can ride the waves of the market. Over the past decade (ending in December 2018) less than 25% of actively traded funds outperformed their passive benchmark, according to Morningstar.
A business is only creating shareholder value with a stock repurchase if the stock is undervalued. If the stock in question is overvalued at the time of repurchase, then shareholder value is actually being destroyed, which means that firms are attempting to game the market and the value of their stock when buybacks are executed. This makes stock buybacks very similar to the underperforming actively traded funds.
Better Uses of Funds
I believe that a growing company should be attempting to create real value with its extra free-cash-flow. Expanding businesses should be investing in R&D, making capital investments to reduce margins, investing in strong positive NPV projects, or even acquiring smaller firms that could create long term value and synergies for the business.
Apple (AAPL) is an example of a company that is spending way too much on stock buybacks. AAPL spent $74.3 billion on stock repurchases in 2018 while only spending $14.2 billion on R&D (over 5x less than buybacks), only $13.3 billion on capital expenditures, and less than $1 billion on acquisitions.
Apple isn’t creating any real value when it is repurchasing stocks. They are essentially just moving money around to raise the price of their stock. I want to see tech leaders like Apple, spending extra money on innovation, technology, and science for the betterment of humanity and all its stakeholders.
Situations When I Believe Buybacks Are Beneficial For All
In a mature industry, like banking, where growth is correlated with economic performance and expansion beyond that is largely made through acquisition, it would make more sense for the long run growth of the company to decrease the cost of capital through buybacks. Obviously, this still needs to be done at a time when the stock price is presumably undervalued, which has its associated risks.
JP Morgan (JPM) has been struggling with keeping its free-cash-flows positive over the past couple quarters and the almost $3 billion in quarterly dividends that the company has to pay out isn’t helping. JPM can’t cut its dividend without damaging its stock price significantly but by repurchasing its stock regularly, they can reduce the long term cost of equity. JPM bought back $20 billion worth of its stock in 2018, a trend that the firm has been following since 2010 when JPM was trading at a considerable discount. They have reduced their total share count by 25% in the last decade.
The ability for a stock buyback to create value ultimately depends on the future value of a business’s stock price, which is very difficult to gauge as you can see from active fund performance over the past decade. For a growing firm like AAPL, extra free-cash-flow can likely be put to more productive use than just buying back stock. In mature industries like banking where the future growth of a firm depends on GDP growth, stock buybacks may be a good option to ease the long-run cost of capital, but only if they are executed at a below fair value price.
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