Buybacks aren’t all bad

Share buybacks have been getting a lot of negative press lately. But they aren’t always a bad thing. As a value investor, it is important to know when a buyback is good and when it’s bad.

When management buy’s back shares which are overvalued, it bad for the long-term shareholders of the company. As a value investor you’d hope that you are not the shareholder of such a company in the first place (remember - value investors hold shares in companies where they believe the intrinsic value is greater than current price, so overvalued shares are a no go in the first place).

Bad buybacks are done for bad commercial reasons and skewed incentives. They tend to benefit a few to the detriment of many – e.g. where management’s bonuses are based on an EPS metric buy-backs artificially increase EPS and benefit the management to the detriment of investors, or where an activist shareholder with no long-term intention puts pressure on the management seeing a large cash pile or asset stripping opportunities. Clearly, such buybacks are bad. As a value investor, if a company you hold is embarking on such buybacks, you are better off selling.

However, there are good bayback too. These are greatly beneficial to a value investor. Any reader of Warren Buffett’s annual letters to shareholders will know that Buffett stands ready to buy-back Berkshire’s shares as soon as its price falls below Buffett’s estimate of intrinsic value. Who better to judge the intrinsic value of Berkshire than Buffett (a good manager will be the best judge of his business’ intrinsic value). And, when a good manager – whose interests are aligned with long-term investors of the company (i.e., who holds a material amount of the shares, and whose bonuses are not judged by silly metrics such as EPS) – decides to buy-back shares, it can be great for a value investor. Why? Because the value investor gets a bigger share of the pie after the buy-back.

Take a simple example: Company A’s operating business has an intrinsic value of 200 plus 15 of cash. The company has 100 shares in issue and a market cap of 150. We will assume zero debt for simplicity. Management decide to buyback shares with the 15 of cash (it does not have any alternative investments available offering a better return that the buy-back). 10 shares are brought back. The operating business is still worth 200, 15 of cash has disappeared, but so have 10 shares. The per share intrinsic value has increased from 2.15 to 2.22. 

As a rule – if a company buys back shares when your estimate of intrinsic value is greater than the price, you should be happy and not sell in the buyback.

Good buybacks work. Great value investors and managers know that.