Unlocking Value: The Benefits Of Strategic Stock Buybacks

Warren Buffett many years ago once got a call from the late Steve Jobs who wanted to find out if he should repurchase Apple shares. Warren asked Jobs two simple questions: Do you have all the money you need to develop the kind of business that you have in your head for the next 5 to 10 years and is your stock selling for less than its worth. Jobs answered “yes” to both these questions, and Warren told him to proceed with the repurchase program.

Let’s dial back a little. What are stock buybacks actually? A stock buyback is a form of shareholder remuneration where a company buys its own shares in the open market thus increasing existing shareholders stake in the business. Buybacks have gained popularity in the last two decades with companies spending more than $1 trillion on buybacks in 2022 according to the WSJ. Buyback announcements are often applauded by the market and are associated with an increase in share price, this can thus give the illusion that all buybacks create shareholder value, however this is not the case.

Going back to Warren and Jobs’ call: for buybacks to create value, two things should hold true. Firstly, the stock must be selling below a conservative estimate of its intrinsic value. If a company is trading for $70 but the intrinsic value of the business is $100, this is equivalent to buying a dollar for 70c. Secondly, the company must have ample cash to take care of the operational needs of the business for a foreseeable period into the future. If these two factors hold true for a company, the buyback program will generate long term shareholder value.

The rules for buybacks seem simple but some management teams will still buyback shares for other reasons other than that the stock is trading below its intrinsic value. If a company buys back stock for any of the following two reasons, they are destroying value:

1.      To boost EPS

2.      To solely offset SBC

Screening for Uber Cannibals, companies that are actively buying back their stock, can result in a quality investing universe to pick from. According to a post on HBR by Alex Edmans, firms that buyback stock subsequently outperform their peers by 12.1% over the next four years. A company that actively decreases their share count over long periods of time shows that management are disciplined capital allocators who are intent on enhancing shareholder wealth, these are the type of people we want running the companies in our portfolio.

Henry Singleton is one executive who used buybacks effectively. Warren Buffett considers Henry singleton as having “the best operating and capital deployment record in American business.” Henry Singleton was the CEO of Teledyne Inc, and if you bought Teledyne stock in 1966, you would have achieved an annual return of 17,9% over 25 years. How did Singleton achieve such returns, by aggressively buying back stock at low valuations.  Between 1972 to 1984 he reduced Teledyne’s share count by 90%.

Mohnish Pabrai in his presentation at Boston College came up with a cannibal return formula, to approximately calculate the returns of Uber Cannibal stocks.

            Cannibal Return Formula= Earnings growth x (100/ Share % left) x Multiple Expansion

According to this formula, if earnings grow 10% a year and 80% of shares are retired and the multiple expands by 50%, that stock will be a 50 bagger in 20 years. During this presentation Mohnish Pabrai listed a couple of Uber Cannibal stocks that you can research: NVR, AutoZone, AutoNation, H&R Block and Jack in the box.

Lastly, if you could see an announcement from a company stating that they will spend a certain amount of money on buybacks in a specific distant year or period in the future, you would probably see that as a plus, right? You should however take such announcements with a grain of salt, as we must remember that the value creation of buybacks is price sensitive, and no one can know the price a stock will be trading at in the distant future. The stock price at that time might not be undervalued and the company may be reluctant to cancel back on that announcement due to fears of how the market will react.

In conclusion, stock buybacks are a powerful tool that when used correctly can generously compound shareholder wealth over long periods of time.

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