Sunday, 23 December 2012

Share buybacks - A thought experiment

Hello world,

I'm often taken to thinking a lot about investing but don't often document my thoughts. I've also realised I'm terrible at keeping notes on the shares I own (and why) and so the desire to change these two things has led me to start an investing blog, more for my own records than anything.

Anyhow, share buy backs. This is an issue that often comes up on private investor websites and opinion is quite divided. I'm firmly in the camp of pro-share buy backs, at the right price. Anti-buy back investors often point to the futility of many companies who have spent considerable sums buying back their stock but have little to show for it.

Even investors who seem to be pro-buy backs often like them for reasons I think miss the point. At a recent Mello investor event I was sat opposite the presenting company's CEO and another PI and the topic of share buy backs was brought up as a way of correcting the company's undervalued share price. "A share buy back will show confidence - that's what will drive the price back up. Also, you'll take out the seller who is putting downward pressure on the stock." said the PI. "No, the business is trading at a discount to net asset value! Buy backs would be incremental to net asset value per share!" I exclaimed. Sadly, both the CEO and PI stared at me blankly for a moment, before moving the conversation on to how good the vegetables were. I think my message may have been sadly lost...

Since then I've been thinking hard about how best to demonstrate why I think my line of reasoning is correct and I have a simple thought experiment/story to demonstrate what I mean - let's hope this goes better than my dinner attempt.

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Undervalued Group Limited is complaining about their languishing share price. No matter how well they seem to do, the market just doesn't appreciate them. For some reason their business of hanging on to £10m in cash and just staring at it doesn't seem to be getting them the kudos they feel they deserve. The stock is trading at £5 per share and there's only 1m of stock outstanding. The balance sheet, being what you'd expect for a company that does nothing but stare at cash, is completely free of liabilities and only has its single asset - £10m in cash. The directors feel, quite rightly, that £1 is worth £1 and so each share should be worth £10.

Here comes along our hero, CantEatValue, who has just been given £5 in pocket money by his parents to invest. "Go along son, do us proud in the capital markets." his dad told him. He promptly finds Undervalued Group Limited and, spotting it is trading at a 50% discount to intrinsic value, makes his purchase of a single share (His broker has kindly offered to waive his first purchase costs and the country both Undervalued Group Limited and our protagonist are based in charge no taxes on anything).

CantEatValue then writes a letter to the directors (who work for free, by the way) urging them to pursue an aggressive share buy back to help close the gap to intrinsic value. The directors, having been too busy staring at the money to have thought of this before, think it's a brilliant idea ("It'll show confidence in our staring-at-cash business!") and begin repurchasing shares. Despite their best efforts, the price doesn't budge from £5 a share. The directors carry on buying and buying stock but it appears that every shareholder, apart from CEV of course, wants to sell at £5 a share! The directors eventually have bought back every single share outstanding other than CEV's lone share and the market price hasn't budged an inch.

"We've failed again! How can the market do this to us?!" the directors say, "It's just not fair!". They tell CEV the bad news, but he rejoices in happiness. "Are you mad?" say the directors, "Nothing has happened! The share price hasn't budged!". CEV pauses more a moment, then smiles.

"It's dividend time."

For CEV knows that he is now the sole owner of Undervalued Group Limited. The directors have spent £4,999,995 buying back the 999,999 other shares and he is the entitled to everything else that is left on the balance sheet - £5,000,005. He collects his £5m dividend and returns to his parents, who are somewhat surprised at their son's 100,000,000% return on his investment. "Not bad, son, how'd you do this then?" his dad asks.

"Share buy backs performed at a price below intrinsic value per share are accretive to intrinsic value per share!" he shouts excitedly.

"Oh. Very nice... anyway, have you tried these vegetables? They really are rather good."

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So this example obviously contains a number of highly contrived elements, but I think the lessons are applicable to share buy backs in general. In this example the intrinsic value of the business was easy, it had no assets other than cash, no operating profits to confuse the matter and no taxes to pay. In the case where you have a business trading below intrinsic value that is based on the net present value of the cash flows from future profits I think the lesson still applies - buying £1 for 50p is good business regardless of whether the £1 is in cash available now or discounted future cash.

The other difference is that, in reality, a complete buy back of all the shares is impossible. My example was deliberately structured to show how ridiculously value creative the buy back was if taken to this extreme but it applies to varying degrees depending on how much can be bought back - each purchase by the company increases the intrinsic value per share of the remaining shareholders. The stock failing to go up is actually a good thing for remaining shareholders as it allows the directors to make more and more of a good purchase. This is what Buffett is referring to where he said that he hopes the IBM stock price does nothing or declines - it increases the effectiveness of their share buy back program on increasing long term intrinsic value per share.

More over, I don't believe this exercise is totally academic. Terry Smith did an excellent presentation* on share buy backs here and on page 34 he shows that the bottom quintile of book-to-market companies who did share buy backs handily outperformed the higher book-to-market quintiles who also did buy backs as well as the rest of the bottom quintile who didn't buy back. While a discount to book is no guarantee of a discount to intrinsic value it's probably a good approximation.

In a real life current example, Wexboy is currently petitioning the management of Argo to perform a buyback amongst other things. The company is trading at a huge discount to the cash & investments per share and even more to intrinsic value. I'm a holder and I wouldn't mind them taking a leaf or two out of Undervalued Group Limited's book!


*For another excellent resource on share buy backs, check out this by Michael Mauboussin

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