Managements claim that stock buybacks are a “return of cash to shareholders”. Over the ten years ending 2014, companies in the S&P 500 used $4.0 trillion or 53% of their $7.6 trillion in earnings to repurchase shares. Dividends paid over the same period measured $2.5 trillion or 33% of earnings.[sup]i[/sup] Dividends are cash paid to shareholders and a source of returns but Anchor asserts that the $4 trillion of share buybacks did not contribute proportionately to shareholder returns. Over this time period the S&P 500 returned 7.7% annually.[sup]ii[/sup] We calculate that dividends contributed 2.0% but buybacks provided just .3% by increasing EPS growth to 5.3% from 5.0%. We estimate that if the $4 trillion had been paid in dividends the total return to shareholders would have been approximately 10.7% versus 7.7% realized with the share repurchases. What happened?
Corporate tax policy allows the value of share-based compensation to be deducted as an expense resulting in a major portion of executive compensation being comprised of various stock option and issuance plans. Anchor estimates based on share count information from Standard & Poor’s[sup]iii[/sup] that approximately 2.0% in additional shares each year have been issued to managements and executives. We conclude that companies have been using cash to repurchase new shares issued to and then sold by management, effectively offsetting the dilution associated with the creation of new shares. Thus value accrues to executives at the expense of shareholders. Because the annual impact is relatively small and providing support to share prices, investors are not aware of this significant transfer of value from owners to management. Our math would suggest that if executives had retained the shares received, they would now own a significant portion of the S&P 500. Executives do not retain all of the shares they receive; either directly or through exercise of options, they sell a major portion of them. Share buybacks have simply been offsetting the increase in shares issued to executives and management, not materially increasing shareholder ownership by lowering companies’ share counts. More recently though, Standard & Poor’s reports that buybacks have been large enough to result in a reduction in shares outstandingiii but we question how much this has added to shareholder value.
Warren Buffett noted in the 1999 Berkshire Hathaway Annual Report that share repurchases are only justified when a stock is bought below “Intrinsic Value”.[sup]iv[/sup] We believe that share buybacks, as with all allocations of corporate capital, should only be done when they are accretive to shareholder value. Our logic suggests that this only occurs when shares are available at a discount to a conservative estimate of intrinsic value. As the graph indicates S&P 500 share repurchases have risen and fallen with earnings. Markets and valuations tend to rise with earnings, and buybacks have been the greatest when markets have reached higher multiples of earnings and lowest when earnings and share prices have declined. Prior to the 2008 Financial Crisis, in 2007 share buybacks peaked at $589 billion or 81% of earnings when the market was selling at new highs and bottomed at $138 billion in 2009 when the market was troughing. More recently, share buybacks in 2014 measured $553 billion, or 54% of earnings. The S&P 500 Index closed 2014 near new highs and sold at 18 times earnings up from 14.7 times at Year End 2012.[sup]v[/sup]
Anchor believes managements must provide firm evidence that buybacks are the best use of earnings and accretive to shareholder value versus supporting share prices as value effectively accrues to executives at the expense of shareholders. Our focus has always been to identify companies whose businesses generate above-average levels of cash flow and whose managements demonstrate a disciplined and shareholder enhancing approach to allocating that cash flow. Anchor feels that as a greater portion of earnings is directed to share buybacks it may suggest that there are fewer opportunities for reinvesting cash flow at attractive growth enhancing returns. Although in 2013 and 2014 buybacks have been large enough to offset the issuance of new shares[sup]v[/sup] and shareholder ownership associated with an absolute reduction in the number of shares has increased, we observe that managements are hesitant to provide hard evidence that their buybacks are adding to shareholder value, probably because that evidence may not exist.
We favor the many companies that have increased the emphasis on dividends as a way to enhance shareholder returns. From 2005 through 2014 dividends increased 6.8% annually but more important from 2011 through 2014 dividends grew 14.2% annually.[sup]vi[/sup] In 2015, Anchor Capital is projecting that S&P 500 dividends will grow 8-9% despite the decline in energy earnings and pressure on energy company dividends. As highlighted in a previous Anchor Capital White Paper on Dividends, managements have become increasingly aware that shareholders need income and are placing higher valuations on those companies with fundamentals that support a sustained and predictable level of dividend growth. While the level of buybacks is discretionary, dividends are considered an obligation and management decisions are driven by meeting this important expectation.
Management’s claim that a company’s buyback plan is a return of cash to its shareholders is evaluated based on: 1) Anchor’s estimate of a company’s intrinsic value relative to the value that a company is selling at in the market and 2) the extent to which the buyback is offsetting share-based compensation for the management. History is full of examples of companies that overpaid for their shares when they had the cash to do so, and then saw the investment in their own shares decline as their businesses deteriorated. Every investment has an element of risk but it is important not to compound that risk with an ill-conceived buyback plan.