Maboussin on Buybacks vs. Dividends

[txlaw]

Found off of Value Investing World:

 

http://lmcm.com/pdf/TheRealRoleofDividends.pdf

[Guest Bronco]

The point on residual cash flow spent on buybacks in accurate IMO (not always, but as a generality).  I would venture that there is higher residual in boom times, with higher stock prices. 

 

Which goes against, buy low, sell high. 

 

Most companies just buy, buy, buy.  Great job CSCO.  Good job HPQ.  Congrats MSFT.

 

Thanks for nothing.

[ERICOPOLY]

He is right:

 

You are making an active decision if you do not sell any shares while a company is buying back stock. Doing nothing is doing something— increasing your proportionate stake in the company by effectively reinvesting.

 

[Guest Bronco]

Lets make a deal that we don't revisit this again.

 

I am already getting a headache.

[txlaw]

He is right:

 

You are making an active decision if you do not sell any shares while a company is buying back stock. Doing nothing is doing something— increasing your proportionate stake in the company by effectively reinvesting.

 

I take it you don't think he's right about the following:

 

But there is an important difference from the investor’s standpoint. With a dividend, all investors are treated equally. When a company buys back its shares when they are overvalued, on the other hand, there is a wealth transfer from the continuing shareholders to the selling shareholders. Symmetrically, when a company buys back undervalued shares there’s a wealth transfer from the selling shareholders to the ongoing shareholders. While the company may return the same amount of cash to shareholders through a buyback or a dividend, how value is distributed can be very different.

 

[ERICOPOLY]

He is right:

 

You are making an active decision if you do not sell any shares while a company is buying back stock. Doing nothing is doing something— increasing your proportionate stake in the company by effectively reinvesting.

 

I take it you don't think he's right about the following:

 

But there is an important difference from the investor’s standpoint. With a dividend, all investors are treated equally. When a company buys back its shares when they are overvalued, on the other hand, there is a wealth transfer from the continuing shareholders to the selling shareholders. Symmetrically, when a company buys back undervalued shares there’s a wealth transfer from the selling shareholders to the ongoing shareholders. While the company may return the same amount of cash to shareholders through a buyback or a dividend, how value is distributed can be very different.

 

 

He isn't saying anything wrong here.  It could be restated as "automatic dividend reinvestment plans are a wealth transfer to selling shareholders from buying shareholders".  I'd completely agree with that, if the shares are overvalued.  If undervalued the wealth transfer would flow in reverse.

 

So he is correct once more.  The trick is to become one of the sellers.  That's obvious, we already knew that.

 

[txlaw]

He is right:

 

You are making an active decision if you do not sell any shares while a company is buying back stock. Doing nothing is doing something— increasing your proportionate stake in the company by effectively reinvesting.

 

I take it you don't think he's right about the following:

 

But there is an important difference from the investor’s standpoint. With a dividend, all investors are treated equally. When a company buys back its shares when they are overvalued, on the other hand, there is a wealth transfer from the continuing shareholders to the selling shareholders. Symmetrically, when a company buys back undervalued shares there’s a wealth transfer from the selling shareholders to the ongoing shareholders. While the company may return the same amount of cash to shareholders through a buyback or a dividend, how value is distributed can be very different.

 

 

He isn't saying anything wrong here.  It could be restated as "automatic dividend reinvestment plans are a wealth transfer to selling shareholders from buying shareholders".  I'd completely agree with that, if the shares are overvalued.  If undervalued the wealth transfer would flow in reverse.

 

So he is correct once more.  The trick is to become one of the sellers.  That's obvious, we already knew that.

 

 

Right, but I think the point is that the CEO does a good job of capital allocation by buying back undervalued shares from willful sellers when the positive value transfer (not creation) that accrues to remaining shareholders is greater than what they could get by investing themselves on average.

 

Essentially, the CEO/CFO is saying to the selling shareholder: "As long as you are trying to transfer your economic stake in the company at X price, which would result in a 15% return over time to the prospective buyer, you might as well let remaining shareholders buy you out on a prorata basis rather than potentially selling to a person who does not currently own a stake in the business."

 

 

[Packer16]

I like Graham's suggestion that if management wants to re-invest more than 30% of earnings they should lay out the plan to shareholders for their approval.  The approval part is my addition to Graham's plan.

 

Packer

[txlaw]

In other words, so long as an inordinate wealth transfer is on the table because of a stupidly selling shareholder, the CEO should sign up all non-selling shareholders to accrue the benefits (as long as all the information required to determine intrinsic value is disclosed).

[ERICOPOLY]

Right, but I think the point is that the CEO does a good job of capital allocation by buying back undervalued shares from willful sellers when the positive value transfer (not creation) that accrues to remaining shareholders is greater than what they could get by investing themselves on average.

 

What's more likely... finding a quality money manager to just run your money (reinvest your dividends) for you if you are a poor allocator, or finding a CEO that not only has undervalued shares (reason why you own in the first place), but also runs his business in addition to knowing more about allocation than your genius money managers?  And then you find out that this CEO wants to change the name of the business to his own, and swipe your cash flows as his "performance fee" or whatever crap he thinks up.  Sometimes best to just hire the able capital allocator (money manager).  Or if you are already a money manager, I suppose you could tell your clients that the CEOs know more about capital allocation than you do, so they'd better just find a more competent money manager in the first place.

 

I find it frustrating when companies just sit on hoards of cash waiting for their shares to be undervalued so that they can return it to us common shareholder folk at long last.  Their superior intellect of course informs them that we are better off to be treated this way.  By the very implication of their saving dry powder for a buyback at such a moment, this must indicate that a wad of cash is just sitting there earning next to nothing in the meantime.  They can start out looking like great value, which is why you buy them, but then later you find out they just want to stockpile the cash that you'd sort of figured was FREE CASH FLOW, but really isn't because it needs to rest for years to fund their ego.

 

Meanwhile, there's all these other opportunities to purchase shares in other companies while we sit and patiently wait for the CEO god to find the right moment -- not all stocks are undervalued at the same time as we all well know.  But the CEO god knows all, and can't possibly be missing the opportunities that we turn up. There's probably not a person on this board that can't allocate a dividend into a reasonable prospect when a given CEO can't find anything -- yet I find the people on this board more supportive of the idea of the all-knowing CEO.  It's kind of ironic.

 

Can you think of any companies you owned at the bottom of the market in 2009 where you would have liked these geniuses who know so much more than you to just give you a dividend so that you could take advantage?  They were probably still buying back shares 9 months later furiously trying to deploy all that cash, even though the market price of the shares had already doubled.  Point being, the bottom doesn't last that long -- not long enough for a company who can only buy 25% of the daily volume and where the company wants to purchase like 25% of the float or something.  Generally if we're excited about a buyback opportunity we're talking about a MEANINGFUL and SIZABLE one right?  The company with it's hands tied on volume is the absolute worst method of deploying cash this way at such a time -- except for taxes.  Name any company you like -- I could have deployed any "special dividend" in seconds.  It takes these guys months if not years to deploy the same amount of cash (on a per share basis) via buybacks -- just too many restrictions.  Academically, it sounds enticing, but in practice these rules make it not quite so good. 

 

Then there is the factor of price -- all that buying by the company, does that support the price at all?  In the absence of an official buyback program, could you get it cheaper with your dividend?  After all, not everyone getting the dividend will reinvest in the same stock --- unless the company is doing it on your behalf.

[txlaw]

I don't disagree with most of what you said in your last post.  I also hate it when companies sit on hoards of cash for no good reason. 

 

And I think that the majority of people on this board would not want buybacks to occur except on rare occasions, and that most board members are quite distrusting of management to allocate capital properly. 

 

Also, there has to be a distinction between people who are good investors (e.g., Ericopoly) -- or who have sound investing principles -- and the average Joe.  The average Joe can't expect to outperform the market for the most part, and he can't be expected to pick quality money managers who won't rip him off over time.  If a high quality company is trading at fair value, let's say at a 7% earnings yield, but can deploy incoming cash earnings at substantially higher rates of return than the market, the company should consider retaining a good part of those earnings and deploying on behalf of its investors.

 

Sometimes, but not often, the proper form of deployment will be in the form of buybacks.  There are certain companies that are undervalued for long periods of time because the market is simply not properly analyzing the companies.  The best managements opportunistically buy back stock at these times as an alternative to deploying capital in other ways -- including dividending out cash earnings and excess cash on the balance sheet -- but only because the rates of return to non-selling shareholders are very high. 

 

An example of such a company is WRB, which is using the bottom of the insurance cycle to cash out selling shareholders in a way that will substantially benefit non-selling shareholders when the cycle turns. 

 

 

[Guest Bronco]

If dividends were taxed at 0%, would anyone think that buybacks make sense?

 

On a different note, I work for a decent size company (10 - 15B market cap) where I know for certain that we are afraid to raise the dividend b/c wall street may "expect that increase".  The leftover cash is used for buybacks (after budgeted cap-ex and expansion and so on). 

 

I do not like this policy, but this is what the author referred to in the link posted.

 

Special dividends are not really used often, partially for this reason I am sure (afraid of signals to wall street).

 

Of course, there's Buffett take on this (it is a Berk and Fairfax board, right?).  Little story about Fred Futile I find pretty interesting.

[ERICOPOLY]

It's funny how many people wonder without certainty why Buffett prefers to wholly own the businesses.  I think it's fairly obvious why.

 

[txlaw]

If dividends were taxed at 0%, would anyone think that buybacks make sense?

 

Yes, in some cases buybacks would make sense over dividends even with a 0% dividend tax.  Why?  Because when good management is in place, they are in a better position to know whether reinvesting in the company at current prices would be optimal for the average non-selling investor.

 

It's a question of the competency of the investor who has his hands on the cash.  In the case of Berkshire, shareholders have WEB acting as our agent, so it only makes sense that all excess cash at the various businesses be directed into his hands.  Someone was complaining about Buffett sitting on cash a couple of weeks ago, but it would be monumentally stupid for Berkshire to raise cash at low interest rates and then dividend the proceeds out to shareholders when WEB can easily deploy that cash at high rates of return with very little risk.

 

[ERICOPOLY]

 

Also, there has to be a distinction between people who are good investors (e.g., Ericopoly) -- or who have sound investing principles -- and the average Joe.  The average Joe can't expect to outperform the market for the most part, and he can't be expected to pick quality money managers who won't rip him off over time.  If a high quality company is trading at fair value, let's say at a 7% earnings yield, but can deploy incoming cash earnings at substantially higher rates of return than the market, the company should consider retaining a good part of those earnings and deploying on behalf of its investors.

 

 

We take lower returns so that others can have more?  This reminds me of my tax bill.

 

 

[txlaw]

Just read the SHLD letter.  An excerpt on buybacks:

 

At Sears Holdings, we seek to create long-term value for our shareholders.  Like Apple, we seek to do so by improving our operating performance, innovating, and delighting customers.  In this area, we have fallen far short of our goals and what we aspire to do in the future.  On the second dimension of capital allocation, I believe that our behavior and focus has served our shareholders well over the past eight years and will magnify the value creation when our operating performance improves.  We built cash when we felt that it was the right decision for our shareholders, and we delivered cash to those who elected to sell their shares when we felt that it was the right thing to do.   

 

Share repurchases are not a panacea, nor are they a singular strategy.  Yet, they are more than just the return of capital to shareholders.  They represent an investment by the non-selling shareholders in the future of the business and the company.  By repurchasing shares from selling shareholders, the remaining shareholders increase their ownership stake, thereby taking the additional risk and additional upside potential based upon future performance.  When coupled with outstanding operating performance, share repurchases magnify returns.  When the price paid is attractive relative to future performance, share repurchases magnify returns.  As a form of discipline on alternative capital allocation strategies, share repurchases can magnify returns.  But, at the wrong price, with poor future performance, share repurchases can harm returns.

[txlaw]

 

Also, there has to be a distinction between people who are good investors (e.g., Ericopoly) -- or who have sound investing principles -- and the average Joe.  The average Joe can't expect to outperform the market for the most part, and he can't be expected to pick quality money managers who won't rip him off over time.  If a high quality company is trading at fair value, let's say at a 7% earnings yield, but can deploy incoming cash earnings at substantially higher rates of return than the market, the company should consider retaining a good part of those earnings and deploying on behalf of its investors.

 

 

We take lower returns so that others can have more?  This reminds me of my tax bill.

 

 

Well, I'm sure we have differences of opinion on the way that the government allocates/redistributes wealth. ;)

 

[ERICOPOLY]

Just read the SHLD letter.  An excerpt on buybacks:

 

Share repurchases are not a panacea, nor are they a singular strategy.  Yet, they are more than just the return of capital to shareholders.  They represent an investment by the non-selling shareholders in the future of the business and the company.  By repurchasing shares from selling shareholders, the remaining shareholders increase their ownership stake, thereby taking the additional risk and additional upside potential based upon future performance.  When coupled with outstanding operating performance, share repurchases magnify returns.  When the price paid is attractive relative to future performance, share repurchases magnify returns.  As a form of discipline on alternative capital allocation strategies, share repurchases can magnify returns.  But, at the wrong price, with poor future performance, share repurchases can harm returns.

 

I only wish I could be his editor.  He spends a lot of ink to say that buying cheap is better than buying dear -- well, "duh" Mr Lampert.

 

[txlaw]

He is pretty wordy.  Definitely not as enjoyable as a Buffett letter.

[Myth465]

He is pretty wordy.  Definitely not as enjoyable as a Buffett letter.

 

I no longer read Maboussin articles. It takes him forever to say something that Howard Marks or WEB can spit out in a few sentences.

[Munger_Disciple]

I no longer read Maboussin articles. It takes him forever to say something that Howard Marks or WEB can spit out in a few sentences.

 

I agree completely. I think Maboussin adds almost nothing new to the topic of dividends & buybacks. What he says is obvious and I don't know why spends so many pages saying it. Is his job at Legg Mason just writing articles?

[Myth465]

I no longer read Maboussin articles. It takes him forever to say something that Howard Marks or WEB can spit out in a few sentences.

 

I agree completely. I think Maboussin adds almost nothing new to the topic of dividends & buybacks. What he says is obvious and I don't know why spends so many pages saying it. Is his job at Legg Mason just writing articles?

 

LOL perhaps he gets paid by the word. They say incentives matter, its the only thing all economist tend to agree on.

[Rabbitisrich]

Just read the SHLD letter.  An excerpt on buybacks:

 

Share repurchases are not a panacea, nor are they a singular strategy.  Yet, they are more than just the return of capital to shareholders.  They represent an investment by the non-selling shareholders in the future of the business and the company.  By repurchasing shares from selling shareholders, the remaining shareholders increase their ownership stake, thereby taking the additional risk and additional upside potential based upon future performance.

 

This seems like more of a moral argument for buybacks (CEO as an implicit financial advisor). The economic argument simply rests in the tax efficiency and, in my opinion, in the behavioral effect. I wonder how long ALD would have survived had it replaced the dividend with a buyback program.

[ERICOPOLY]

Just read the SHLD letter.  An excerpt on buybacks:

 

Share repurchases are not a panacea, nor are they a singular strategy.  Yet, they are more than just the return of capital to shareholders.  They represent an investment by the non-selling shareholders in the future of the business and the company.  By repurchasing shares from selling shareholders, the remaining shareholders increase their ownership stake, thereby taking the additional risk and additional upside potential based upon future performance.

 

This seems like more of a moral argument for buybacks (CEO as an implicit financial advisor).

 

It's also beating around the bush.  If the CEO is supposed to somehow guide investors, then why don't we expect him to say "we don't think the shares represent good value at this time", and just leave it at that. 

 

Sometimes the direct approach is overlooked.  As my grandmother told me a few days ago "why make something simple when it can be made complex". We were chatting about the bureaucracy of my getting my Australian passport renewed at the time.  Of course, one of the guarantors that I found had a lovely comparison between bureaucracy and a rhinoceros: you can't get around it and you can't offend it.  Is the CEO the rhinoceros?

 

 

 

 

[txlaw]

You guys are the ones making this overly complicated. 

 

Look, the whole point of a public company retaining "owner earnings," rather than distributing them, is to reinvest those earnings on behalf of the shareholders, who benefit, get hurt or stay the same from reinvestment on a pro rata basis. 

 

Whether or not we're in a tax free world, if management cannot turn each $1 of retained owner earnings into more than $1, then all owner earnings should be returned to shareholders.  I would go further and argue that unless management can do substantially better than shareholders, as a class, could do by investing that capital on their own, those owner earnings should be distributed to shareholders to do what they wish with it (consume or invest).  Some, like Packer, would institute a bright line rule requiring that 70% of owner earnings must be distributed to shareholders unless shareholders affirmatively agree to allow more reinvestment by management.

 

The economic argument for buybacks versus dividends cannot rest solely on the tax consequences of dividends.

 

In a tax free world, when a company declares a dividend, shareholders actually get capital in their hands which they can use to either consume or invest.  With company-instituted buybacks, on the other hand, the non-selling shareholders have been forced to reinvest in the company by buying out selling shareholders.  The price paid to cash out the selling shareholders will affect whether non-selling shareholders are better or worse off for having distributed company cash to the selling shareholders.  Only in an academic fantasy world, where shares of a firm are always bought and sold at "fair value," are buybacks equivalent to dividends.

 

The only valid reason for company management to institute a buyback is to arrange a cash out transaction between selling and non-selling shareholders that benefits non-selling shareholders in a way that would be superior to using company cash for real investment.