From 2004 through 2011 the S&P 500 companies spent $2.7 trillion buying back their own stock. A recent article in the WSJ discussed how companies tend to buy back their stocks when they are flush with cash, which usually happens during market boom periods. But when markets are booming, it is likely that companies’ stock prices are also high. In other words, companies buy back their stock when it is likely to be overvalued. In fact, according to this Thomson Reuters report, share repurchases have a 76% correlation with the value of the S&P 500.
This is an interesting problem. Management should know the most about its stock (in theory, at least) and be the most rational about it. So in an informationally-inefficient market, management is the most informationally-efficient. Then why does it behave so irrationally? There are three possible reasons right off the top of my head:
- Just because it knows the best time to buy the stock, it may not have the necessary cash to buy it back. This continues to assume that management is rational, but it still acts irrationally.
- Management is acting on behalf of its stockholders, so they benefit the most when the stock price is at its highest. A naive reason, but still (potentially) valid. Not sure I agree with it myself, but in the long term this could bode well for the company’s reputation. This also assumes that management is rational.
- Management is not acting rationally at all, i.e., management is acting like investors do, and working off of momentum or buying when the market is going up and selling when the market is going down.
There is of course, another reason and that is that executives would like to exercise their stock options when they are in the money (or profitable), which is the case when the stock price is high. So they buy back shares at low pre-agreed-upon prices to resell them back into the market at their boom prices. In which case, management is a rational investor, but an irrational executive, which is a moral hazard problem. In other words, management is acting in its own interest, and not the company’s best interest. This seems the most likely to me.
All of that said, it is not necessarily the case that all share repurchases are done at bad times. Here is a list of six companies that do share repurchases well. The Thomson Reuters report that I mentioned at the beginning of the post lists a few more companies that have done it right. Warren Buffett says that stock buybacks should only be done when the stock price is below its intrinsic value. Here is what he has to say about it in his 1999 shareholder letter:
Repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: To pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated. Nor will we attempt to talk the stock up or down. (Neither publicly or privately have I ever told anyone to buy or sell Berkshire shares.) Instead we will give all shareholders — and potential shareholders — the same valuation-related information we would wish to have if our positions were reversed. [link]
So the upshot of all of this is that the best time for a company to buy back its shares is when their value is below intrinsic value. But what is intrinsic value? As Spencer Jakab from the WSJ says, “[intrinsic] value is in the eye of the beholder.”