Given my empirical observations about buybacks two weeks ago, it’s nice to see my instincts backed up by hard data. Henry "Big" McVey, strategist at Morgan Stanley (who has been on right on target with his market calls), published an interesting report on the effectiveness of buybacks on Friday. He basically concludes that buybacks aren’t worth getting excited about, unless a company’s fundamentals are already strong or the company buys back more than 10% of the foat. The following are excerpts from McVey’s Dec 2 report –
How much is enough?
Albert Einstein said that, “I am enough of an artist to draw freely upon my imagination. Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world.” While it is clear that Einstein had enough grey matter to be a lot of things to a lot of people, I can think of many instances where enough is just not enough. Take buybacks, for example. Every day we read about American corporations announcing — often with great fanfare — that their boards have authorized a repurchase of their common stock.
What often is not mentioned in the company press releases or follow-up reports from the analyst community is that actual share price improvement in response to the announcement is actually quite minimal. In particular, investors should be skeptical of share repurchase announcements that are less than 4.0% of total shares outstanding. Our bigger-picture conclusion is that capital management programs, even significant ones, cannot — in isolation — usually overcome poor business bundamentals. Instead, we think that a more compelling investment strategy, which we detail below, is to buy companies with aggressive capital management programs and solid earnings growth.
Where’s the Beef?
Measuring actual buyback activity is actually quite difficult. In fact, it is so difficult that we could not find a reliable way to track buyback announcements and corresponding actual share repurchases. So, we ended up using just buyback announcements because that is what is most clearly reported to investors. It is also the information that investors must use to make near-term buy and sell decisions. As Exhibit 2 shows, buyback announcements are surging this year. Year-to-date, there has already been $247 billion of announcements made; on an annualized basis, current trends would represent $269 billion, well more than last year’s $241 billion, which included MSFT’s $30 billion announcement. That’s the good news.
The bad news is that buyback announcements do not generally lead to actual share reductions. One need only to look at Exhibit 3, which shows that just about 50-60% of companies announcing buybacks actually deliver share count reduction in aggregate during any given year. The issue, as we see it, is that while share repurchase announcements make good headlines, they do not always represent good ‘buy’ signals. The major problem is that they are often just too meager in scope to make a difference, particularly in light of heavy options issuance. In fact, about half of all share repurchase announcements are for less than 4% of existing shares outstanding. There are two other issues to consider.
One is that corporations are often more apt to announce buybacks than to actually complete them in a timely manner. The data are difficult to reconcile in some instances, but as best as we can tell, announced S&P 500 share repurchases exceeded completed share repurchases by about 28% in 2004. Second, the lion’s share of buyback activity these days is linked to containing option-related dilution and funding corporate retirement plans (have you ever thought about how companies fund 401(k)’s with company stock!).
Given these headwinds, we were not surprised to see that the median relative return on the day of the announcement is just 30 basis points. The subsequent one-week return is 90 basis points. As one might expect, larger share repurchase programs generate higher returns, particularly when a company announces it is going to reduce the shares outstanding by more than 10%.
We also looked into whether buyback announcements generated strong relative performance after a few months. What we found was that the same holds true for varying periods of three months, six months, and twelve months after the buyback announcement. The median relative performance for share buybacks less than 4% is 0.6%, 2.4%, and 4.5% on a one-week, three-month, and twelve-month basis, respectively. However, relative performance for buybacks in excess of 10% for the same subsequent periods is 2.4%, 6.0%, and 14.8%, respectively.
Do Not Lose Focus
While buyback announcements make good fillers in press releases and often sound encouraging on conference calls, they often don’t get the job done at the share count level. Equally as important, they are not a substitute for underlying growth in a company’s core business. Consistent with this thesis, our work illustrates that companies with higher earnings growth generally deliver better relative performance after announcing a buyback than companies with low or negative earnings growth. One can see this in Exhibit 6. Our basic premise is that companies that are disciplined about returning the free cash flow in excess of what their core business requires are the companies on which to focus. Names to consider include MO, PEP, PRU, ASD, and XOM.
Told you so.