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Buybacks have exceded free cash flow for the first time since the financial cris


LC
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Not good. What are managements thinking? To return 100%+ of all annual earning to shareholders leaves no margin of safety. Or just dumb management buying at any price. It seems a bit speculative. Notice Berkshire is doing almost the exact opposite. Piling up 100 billion in cash, nibbling some buybacks as Berkshire dips around $200 but nothing major. Maybe some CEOs should stop and ask if a great investor is doing the exact opposite of them all as a group, what does it mean?

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there are 437 companies in the S&P 500 ex financials. Those companies have a median and average net debt to EBITDA of 2.2x and 3.0x (the average only counts levered companies).

 

Of the top 100, which comprise 70% of the market cap, the median is 1.6x.

 

The weighted average of all 437 companies is 1.2x, again because the big market caps like MSFT, AAPL, AMZN, Alphabet, Facebook, Visa, Johnson and Johnson, Walmart Exxon, PF, and Mastercard (literally the top companies in order, all of which are less then 2x or net cash companies) are either net cash or low debt.

 

In my humble opinion, top down concerns regarding corporate leverage don't apply to most people's portfolios. PE portco's are where all the leverage is. That's not to say there won't be knock on effects, but the public equity universe just doesn't seem to have many junk borrowers. IIRC, about 3% of the S&P 500 are junk credits.

 

I wish I could do it for the Russell 2000, but I don't have access to a quick excel of the Russell 2000 ex financials and am not going to do anything that takes much time.

 

I'm not saying that buybacks are necessarily the best use of capital for all companies, but corporate publicly traded america isn't exactly levering to the hilt to take in shares.

 

Banks also appear to me to be very well capitalized.

 

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Goog point pupil. I recall hearing a lot of the same thing around 2012 and then taking a peek at many of the market favorites. My thoughts were basically the same. WTF are people talking about? Most of these companies are HUGELY net cash.... I see more or less the same today, just to a slightly lesser extent.

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I'm not saying that buybacks are necessarily the best use of capital for all companies, but corporate publicly traded america isn't exactly levering to the hilt to take in shares.

 

Banks also appear to me to be very well capitalized.

Cannot argue with you but the more concerning aspect is not a buildup of balance sheet but it may signify a lack of reinvestment options.

 

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I'm not saying that buybacks are necessarily the best use of capital for all companies, but corporate publicly traded america isn't exactly levering to the hilt to take in shares.

 

Banks also appear to me to be very well capitalized.

Cannot argue with you but the more concerning aspect is not a buildup of balance sheet but it may signify a lack of reinvestment options.

 

Honestly, I have a hard time with this argument. Reinvestment options are screaming in infrastructure. Obviously, I understand not every company is going to invest in that, but U.S. infrastructure could absorb a large portion of those dollars and there would still be a need for modernization.

 

Obviously this points to a lack of incentives, or disincentives, to invest in the real economy. I wonder what thos could be.....

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Capacity in most industries are probably more than enough right now.. I mean, would open new mills, or new stores, or new restaurants in this environment?

 

I agree with your argument for the need in Infrastructure, but it’s not in the mandate for most of the companies to invest in Infrastructure.

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Listening to some people here and this article, you can easily come to the wrong conclusion that money made by corporation or corporate treasury used for buybacks suddenly died: a black hole sucking all dollars out of the economy.

 

Indeed, someone sold this stock to the corporation and received cold hard cash for it. Where does it go in society after?

 

It could be to fund a kid's education, develop a small business, build a new house and even to pay taxes... Money does not die and you can't take it with you, it goes around.

 

And as explained by ThePupil, comparing an average of an average is dumb.

 

So please don't fall for the trap that some of the politicians have set up regarding how evil this activity is.

 

Cardboard

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I use specific company buyback decisions when assessing capital allocation skills. In the past, because the firm had been repurchasing at prices felt to be too high, I've sold holdings too early or that should have stayed inside the portfolios.

-----

Here are two recent references that I found useful when trying to reach fact-based conclusions:

https://www.goldmansachs.com/insights/pages/top-of-mind/buyback-realities/report.pdf

https://www.yardeni.com/pub/buybackdiv.pdf

 

Fact-based conclusions:

-Increased buyback activity has been very significant in the market

-Increased buyback activity has not occurred at the expense of R&D or capital expenditures (maintenance and growth)

-Dividend component of the payout has gone down

-US firms have simply become so much more profitable in the aggregate because of relevant income statement lines:

    -decreased workers' input costs (US and global)

    -decreased interest costs (debt-servicing lower despite much higher corporate debt level versus GDP)

    -decreased effective tax rates (despite higher public deficits and debt to GDP and growing off-balance sheet and unrecognised public

      liabilities)

 

Next-level opinion:

It is interesting to note that the rising tide has resulted in equity holders harvesting a lot of the 'excess cash' and this happened at a time when the typical worker (who tends to hold little stock) saw his or her share of the pie diminish. Like most developed countries and much like a firm that goes through stages (venture formation, growth, maturity etc), it could be argued that the US has reached, for the foreseeable future, a mature phase (because of demographics and being stuck in low levels of productivity {even Mr. Peter Thiel has recently acknowledged this last aspect}). The opening poster LC likely wanted to underline the policy challenges related to this issue but, in this post, I will stick to the investment side because who knows how people behave when they become mature.

-----

There are two specific examples of the share repurchase that are relevant these days.

 

Aimia is a company that is trading below intrinsic value (IMO) for both types of equity and it has recently completed a tender offer and continues to repurchase shares in the market at a time when they may need a 'war chest' in order to sell assets and liquidate or go through an evolution of their business model. It's a thin line.

 

Corvel (company involved in third-party administration or workers comp claims) is a company I know very well and it has been a cannibal. It has bought about 65% of its shares since 1996. Retrospectively, the IRR achieved in this activity, so far, has been very satisfactory and the company has shown the ability to reinvest in their business and grow revenue and the ability to use the 'excess cash' to buyback shares, sometimes opportunistically. However (IMO), the company is reaching a mature stage (possibly just a plateau) and it has become more difficult for the company to not build excess cash (à la Mr. Buffett). In their Q2 report released yesterday, their cash balance reached 104.4M, which is 7.1 x more than in 2009 (vs revenue x 1.9). Despite a security breach announcement yesterday, the firm trades at a PE of 30-35 with an earnings yield which, relatively, is barely higher than long-term government yields.

 

A while back, I had held for a few years a regional and boring furniture retailer (Brault & Martineau, GBT.TO). 40 to 50% of the total return (along revenue growth, margin expansion, multiple expansion and dividend) came from the share repurchasing activity.

 

Conclusion: Firms have excess cash and they use it for buybacks but it's a capital allocation decision and dumb moves can be made although shrewd and opportunistic buybacks can contribute greatly to overall results. For most, share buybacks is pro-cyclical. Not necessarily in a cause-and-effect way but in the sense that firms tend to increase buybacks in good times and and curtail them in bad times which tends to cause cognitive dissonance for value investors.

 

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Great post! I've been looking at GBT - seems like they might have a bit of a moat (local scale, language barrier for national entrants) and are down substantially (on poor results) recently. I'd be curious if you've continued to follow them, and if you have any thoughts. Big risk to me seems macro - if QC housing does poorly for a few years they will struggle, but I think it is a business that probably deserves to exist.

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-----

Here are two recent references that I found useful when trying to reach fact-based conclusions:

https://www.goldmansachs.com/insights/pages/top-of-mind/buyback-realities/report.pdf

https://www.yardeni.com/pub/buybackdiv.pdf

I would suggest those interested read the interview with Damodaran in the GS report you linked.

 

Allison Nathan: But are these cash-rich companies

engaging in buybacks just not looking hard enough for

opportunities to innovate?

 

Aswath Damodaran: You can look as hard as you want. You

can make a reincarnated Steve Jobs the next CEO. But you

can’t change many of these businesses. The fact of the matter

is that many of the companies engaging in the largest buybacks

are in the late stages of their lifecycles, and you can’t reverse

that aging.

 

Another good point is actually the question prior to this one, where AD talks about re-allocation of capital as Cardboard alluded to. However I am not sure I would agree with that point.

 

The opening poster LC likely wanted to underline the policy challenges related to this issue but, in this post, I will stick to the investment side because who knows how people behave when they become mature.

A bit rude, no?  :-[

 

I wanted to discuss the factors causing firms to drastically increase buybacks. Now of course we know where the cash comes from, as mentioned a lot of this excess cash comes from tax reform and the fact that many SP500 juggernauts are late-stage cash cows. But firms still have a choice how to spend this exesss cash, i.e. return to shareholders vs. invest in the company.

 

Rate of capital investment does not appear to have changed trajectory over the past 5 years or so. Wouldn't one therefore conclude that internal investment opportunities have been essentially exhausted, hence the decision to return the majority of this excess cash to shareholders?

 

So where are the best marginal opportunities for reinvestment, if not in the SP500 companies which have dominated the past decade? Financials, Real Estate, Consumer Staple/Discretionary, Autos...all seem "tapped out". Even tech appears closer to this end of the spectrum. One poster suggested infrastructure, this seems reasonable. But I think this is a real question that the US economy will have to face over the coming years. That is the question I wanted to underline.

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I think I disagree with Damodaran. I think (especially tech) companies could invest way more into new businesses especially if they had reincarnated Steve Jobs as CEO. Clearly Alphabet does a fair share of it and could do even more. Other companies like Apple, Microsoft, Facebook, etc could also do a lot more. There are couple of issues though:

 

- What is the expected ROI? I'm pretty sure you can throw way more money into quantum computing, VR/AR, new drug modelling, building even better AI systems for existing and new domains, self driving cars, space, etc. But expected return is possibly not that high (if positive). And shareholders would likely be even more unhappy about funding moonshots than share buybacks.

- People on CoBF hate money losing unicorn startups/IPOs, but that's likely more accommodating platforms for spending tons of money on questionable ROI projects. Even there there is certain conservatism unicorns/IPOs nonwithstanding. It's much easier to get startup/VC/Masa/IPO funding for multi-billion customer facing or B2B software businesses than, for example, quantum computing or compact nuclear reactor.

- At least on the tech side, there's likely labor shortage. We already know about escalating salaries. It's quite possible that if you wanted to make another A-class team or expand your A-class team size 2x-10x in any areas above, you would just not be able to hire people.

 

Edit: also that Musk fellow; and that Bezos fellow. Give them money if you really think there are no areas to innovate or grow businesses in.

 

 

If Damodaran's "reincarnated Steve Jobs the next CEO" really means "CEO who can find overlooked low hanging fruit (yeah that) that everyone else missed and develop it into high ROI trillion dollar business within couple years", then I agree that this is unlikely. Steve Jobs or no Steve Jobs paradigm shifting breakthroughs like PC, mobile phone, smart phone, electric car, self-driving car happen maybe once in a decade at best.

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...

The opening poster LC likely wanted to underline the policy challenges related to this issue but, in this post, I will stick to the investment side because who knows how people behave when they become mature.

 

A bit rude, no?  :-[

 

I wanted to discuss the factors causing firms to drastically increase buybacks. Now of course we know where the cash comes from, as mentioned a lot of this excess cash comes from tax reform and the fact that many SP500 juggernauts are late-stage cash cows. But firms still have a choice how to spend this exesss cash, i.e. return to shareholders vs. invest in the company.

 

Rate of capital investment does not appear to have changed trajectory over the past 5 years or so. Wouldn't one therefore conclude that internal investment opportunities have been essentially exhausted, hence the decision to return the majority of this excess cash to shareholders?

 

So where are the best marginal opportunities for reinvestment, if not in the SP500 companies which have dominated the past decade? Financials, Real Estate, Consumer Staple/Discretionary, Autos...all seem "tapped out". Even tech appears closer to this end of the spectrum. One poster suggested infrastructure, this seems reasonable. But I think this is a real question that the US economy will have to face over the coming years. That is the question I wanted to underline.

 

LC,

 

Personally, I appreciate much that you have taken the initiative to this discussion.

 

Also, personally, I think you that you may have - severely - misread the emphasized above. [Please note I'm not Cigarbutt, and naturally Cigarbutt can reply for himself.] My personal angle is as follows : Both Cigarbutt and I are not US citizens, so, we are observers of what's going on in the US - as investors. Maybe Cigarbutt may disagree with me here, so this is written on personal behalf : Seldom have I experienced and perceived USA so divided than as of now. [Ref.: Cigarbutt's use of "mature", that I personally think was in no way addressed at you personally.]

 

- - - o 0 o - - -

 

In short : For long term investments [i.e. infrastructure investments] to take place in the US for USA to become a better place for all, a political stability with a long term horizon for decisions is absolutely imperative. To me, the political system in the US simply just hasn't been able to provide that recently. No fingers pointed. It requires two parts to collaborate & cooperate, as well as it requires two parts to get into endless arguments. So I also speculate that Cigarbutt's "mature"-comment is about taking real responsibility. -Period.

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I think the investment is done now more in nonpublic startup companies or those just past the IPO hurdle than it used to be. Space X, Uber and other Unicorns all these biotech startups spent plenty and perhaps some what foolishly in come cases, but some work out and will mature into major companies.

 

In the past we had Xerox Parc and ATT labs but those didn’t really benefit their parent companies all that much, although they created plenty of benefit for others. now it’s outsourced and institutionalized kn dedicated startups.

 

Then the other fact is that companies have become way more capital light, and more profitable at the same time, which generates higher FCF and hence allows for more buybacks.

 

 

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John, I think you’re right especially knowing Cigarbutt is never anything but cordial. The sentence just read so oddly to me that I had to ask!

 

And more so, a fair point to make. To approve massive infrastructure spending, both parties need to buy in. Very difficult in today’s environment.

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@LC

Apologies if I misinterpreted and misrepresented your intentions because I somehow imagined that you enjoyed discussing policy challenges :). The comment also was meant to avoid triggering a political derailment (interesting topic but real risk here). The essential meaning was basically what John said. Your country seems to have reached some kind of a ‘mature’ stage (of which higher share repurchase activity is a symptom) and is (IMO) in need for another stage of creative destruction. Ray Dalio has recently described what he calls the coming paradigm shift and comments on what has been the driver behind debt-fuelled share repurchasing activity.

https://economicprinciples.org/downloads/Paradigm-Shifts.pdf

-----)Back to the 'real question'  :)

 

@bizaro

For GBT.TO, in the past and over the long term, they have adapted well to an evolving competitive landscape (for example with The Brick which is now part of Leon) and are likely to eventually benefit from a return to more ‘normal’ conditions, although as you say it may get worse before it gets better. In terms of figuring out if the entry point is adequate, I will have to look into the continuity of leadership issue because the long-serving CEO has been unusually smart with capital allocation. On typical value and contrarian bases, this looks like a potential opportunity. It may even eventually deserve its own thread with numbers and valuation etc. Do you think new entrants like Wayfair may cause an enduring new wrinkle in the industry?

 

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@LC

Apologies if I misinterpreted and misrepresented your intentions because I somehow imagined that you enjoyed discussing policy challenges :). The comment also was meant to avoid triggering a political derailment (interesting topic but real risk here). The essential meaning was basically what John said. Your country seems to have reached some kind of a ‘mature’ stage (of which higher share repurchase activity is a symptom) and is (IMO) in need for another stage of creative destruction

I figured as much! I should have given you the benefit of the doubt, my bad! No hard feelings and of course I agree on both items (the "real risk"  ;D) and the fact that the US does seem to be reaching a mature stage and this requires different incentives etc. Thanks for the link as well.

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