U.S.A., Inc.: Another Historic Misallocation

This week, the Financial Times reported that U.S. companies are announcing share buybacks at a rate unequaled since Lehman Brothers' bankruptcy. Surely, this is a clear sign of growing confidence of the corporate sector, as well as a catalyst for further stock market gains. However, today's buybacks also perpetuate companies' gross misallocation of shareholder capital. After selling their own shares low, they're buying them high.

This is not a good entry point
Let's be quite clear about the underlying economics of these transactions. Share repurchases are picking up now that the market has already doubled off the March 2009 low. Meanwhile, that low occurred immediately before company share issuance hit a cyclical high.

On the topic of buybacks – as on most others relating to investing -- it's useful to seek the counsel of arguably the greatest capital allocator of all, Berkshire Hathaway CEO (NYSE: BRK-B  ) Warren Buffett. In his 1984 Letter to Berkshire shareholders, he wrote:

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.

Surely you want to buy low and sell high -- right?
By that standard, S&P 500 companies as a group won't be doing their shareholders any favors with these repurchase programs. The chairman of GMO, Jeremy Grantham, reckons that the index is worth roughly 910, suggesting that it's now priced at a 47% premium beyond its fair value. If that's true – and Grantham's track record suggests he knows a thing or two about value -- companies should be eager to sell shares, instead of ramping up their buying.

Unfortunately, the pattern is familiar: With the previous cyclical bull market under way, share buybacks for the S&P 500 accelerated in the second half of 2004, capped off with a sharp spike during the first two quarters of 2007 – just as the stock market was peaking. Similarly, there was a spike in share buybacks during the second half of 1999 through the first quarter of 2000, as the technology/ large-cap share bubble was having its last hurrah.

Five companies to watch closely
Not all companies have the same record in regard to buybacks and repurchases -- although very few demonstrate consistently good results on this front. The suspect companies in the following table bought back huge bunches of shares during 2006-2007:

Company

Total Value of Share Repurchases as a % of Average Market Capitalization, Q1 '06–Q3 '07

Agilent Technologies (Nasdaq: A  )

22%

Biogen Idec (Nasdaq: BIIB  )

21%

CenturyLink (Nasdaq: CTL  )

24%

Goldman Sachs (NYSE: GS  )

18%

Valero Energy (NYSE: VLO  )

17%

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

That's right -- even the finance whizzes at Goldman Sachs (NYSE: GS  ) are guilty. During the go-go years of 2006 and 2007, the bank repurchased nearly $17 billion in shares. Then it turned around and issued roughly $12 billion of common stock from Q4 2008 through Q2 2009, during the worst of the bear market. (Let's not forget that very costly preferred offering to Warren Buffett, either.) That isn't God's work, Mr. Blankfein -- it's a capital sin.

This business genius got it right
Executives from these companies could take a lesson from a master capital allocator from yesteryear: Dr. Henry Singleton, the founder and former CEO of Teledyne (NYSE: TDY  ) . Singleton was a real genius -- he won the William Lowell Putnam Mathematical Competition while at MIT – and an outstanding businessman. Warren Buffett once said that Singleton had the best operating and capital deployment record in American business.

When Teledyne's shares were richly priced, as in the 1960s, Singleton would never have dreamed of buying them back. Instead, he used them as currency for acquisitions. However, once the secular bear market of the 1970s had laid waste to equity valuations, Singleton became an active buyer of Teledyne shares. Between 1972 and 1984, he tendered for the shares eight times, ultimately reducing the number of shares outstanding by roughly 90%. The stock, which changed hands for less than $6 in 1972, was worth more than $400 in 1987 on a split-adjusted basis.

Shortly before he died in 1999, Henry Singleton told Leon Cooperman, an investor and former Goldman Sachs partner, that too many companies were doing share repurchases, and that there must be something wrong with them. If he were around to witness this market, I think he might sound the same warning today.

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Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Berkshire Hathaway is a Motley Fool Inside Value recommendation. Berkshire Hathaway is a Motley Fool Stock Advisor selection. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (25) | Recommend This Article (33)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 23, 2011, at 5:30 PM, daveandrae wrote:

    Unbelievable-

    Yet another example of some very, BAD, journalism.

    Pfizer stock has been oscillating (rather wildly) around a market price of 18.75 for the last fourteen YEARS, current trades at eleven times 2012 earnings, in a zero percent interest rate environment for cash, and you think a five billion dollar share repurchase program is a misallocation of shareholder capital???

    On top of all of this, it should be fairly obvious to the reader that you value Jeremy Grantham's opinion, who is NOT the messiah, more than your own.

    You people really need to stop printing this kind of crap. It's insulting to those of us that know how to think for ourselves.

  • Report this Comment On February 23, 2011, at 5:56 PM, LQM2 wrote:

    Management keeps buying back shares instead of paying dividends because they have huge option grants and get paid on stock price instead of total return. How about writing an article about that travesty?

  • Report this Comment On February 23, 2011, at 6:06 PM, TMFAleph1 wrote:

    @truthisntstupid

    Thanks for your comments; it's nice to hear from someone who actually read the article before firing off a comment.

    Alex Dumortier

  • Report this Comment On February 23, 2011, at 6:38 PM, bgotchall wrote:

    There is a comment in the article about a "secular" bear market. I suspect this was supposed to be "cyclical"

  • Report this Comment On February 23, 2011, at 7:04 PM, daveandrae wrote:

    Anyone with half a brain stopped reading your nonsense after the first paragraph.

    It's a joke.

    I could have easily substituted Pfizer for, say, JP Morgan, Hewlett Packard, Microsoft, Intel, Cisco, GE, Wal-Mart, Merck, McDonalds, Johnson & Johnson or Best Buy.

    Right NOW, the list of cheap stocks is so long it ain't even funny. At 1300, the s&p 500 is barely trading above 12 times 2011 earnings. Thus, to even suggest that "U.S.A. Inc," is misallocating shareholder capital with buybacks, when interest rates are at ZERO PERCENT is laughable.

  • Report this Comment On February 23, 2011, at 7:06 PM, TMFAleph1 wrote:

    @bgotchall

    Thanks for your comment, but I stand by the statement that the 1970s were part of a secular bear market.

    Alex Dumortier

  • Report this Comment On February 23, 2011, at 7:31 PM, rb525 wrote:

    Goldman was forced to issue shares after their stock had crashed in the crisis. They were extremely over leveraged and they needed to raise capital. It's not as though they wanted to, or that they thought it was a good time to sell high, it as a matter of the firms survival.

    Also, the S&P is only trading around 14X TTM earnings. I don't disagree with your article, but why do you think that the stock market is over valued at this point? I don't really think that the fact that the index has doubled in a couple years really has anything to do with its actual value. I mean, look at a company like Ford: they doubled up within 6 months of their low on November 28, and then they turned around and more than quadrupled after that.

  • Report this Comment On February 23, 2011, at 8:32 PM, vidar712 wrote:

    @rb525

    If they didn't spend $17 billion on share buy backs, they wouldn't have needed to raise $12 billion two years later.

    @daveandrae

    Where are you getting the earnings for 2011 and 2012? I would find this information VERY useful.

    Based upon your comments it appears that the most logical choice would be to borrow money (at ZERO PERCENT!!!!11111) and use the borrowed money to buy back shares.

    @hnhm111

    In America we put the currency symbol in front of the amount. For instance: Jordan Shoes....$28. Also, it appears that your keyboard is broken. You seem to be typing zeros instead of the letter 'o'.

  • Report this Comment On February 23, 2011, at 8:53 PM, NovaB wrote:

    What I see is an economy close to collapse as a reaction to unstable politics foreign and domestic.

    Domestically, Republicans with regressive policies are doing everything they can to halt discretionary spending.

    World markets are boiling over an unstable oil supply due to anarchy spreading across the middle east.

    Where does one put their money now?

  • Report this Comment On February 23, 2011, at 8:58 PM, tkell31 wrote:

    "However, today's buybacks also perpetuate companies' gross misallocation of shareholder capital."

    Am I on drugs? A guy makes a very valid point about PFE, and then some idiot bashes his comment and TMF is vindicated? I'm prettys sure that sentences encompasses all companies, not just stupid companies. How about INTC? I think they are doing one of the biggest buybacks out there, are they "grossly misallocating" shareholder capital as well?

    Hmmm, I seem to recall reading this brilliant statement as well:

    "After selling their own shares low, they're buying them high.

    "This is not a good entry point

    Let's be quite clear about the underlying economics of these transactions. Share repurchases are picking up now that the market has already doubled off the March 2009 low. Meanwhile, that low occurred immediately before company share issuance hit a cyclical high."

    Any qualifiers there? None that I can read. So yes, this is a rather stupid overly broad article that relies on comparisons to the 70s...seriously folks...the 70s as support for the idea that share buybacks are bad. Or do you disagree that the market is substantially different then it was 40 years ago? Obviously selling low and buying is bad, I'm pretty sure we dont need an article to tell us that.

    You did list five companies to watch out for...whether they are actually doing any buybacks now remains unknown.

    And to wrap, confirmation that this article is unqualified:

    "Shortly before he died in 1999, Henry Singleton told Leon Cooperman, an investor and former Goldman Sachs partner, that too many companies were doing share repurchases, and that there must be something wrong with them. If he were around to witness this market, I think he might sound the same warning today."

    In light of the broad generalizations defending a particular stocks buybacks TODAY seems like a very valid point to make.

    I also have to laugh at truth who rushes to your defense like a good little lap dog.

  • Report this Comment On February 23, 2011, at 9:20 PM, TMFAleph1 wrote:

    For anyone who struggled to understand the article, let me repeat what is already stated explicitly in the text: I am reasoning at the level of the S&P 500 as an aggregate.

    Alex Dumortier

  • Report this Comment On February 24, 2011, at 12:18 AM, Mstinterestinman wrote:

    Yeah when you spend that much on buybacks and you end up cutting your dividend to raise cash makes you really question management.

  • Report this Comment On February 24, 2011, at 12:48 AM, Merton123 wrote:

    Alex - What do you mean by the word "secular" bear market in 1970?

    Alex has raised an interesting question - why do companies buy back their shares?

    Benefits:

    1. They don't have to pay dividends on their treasury stock.

    2. The share repurchase makes it more difficult for other companies to buy them. For example - Over half of Bank of Hawaii Stock outstanding is treasury stock. Treasury stock is a technical term for stock that has been repurchased. The company can't vote their treasury stock. The remainder of the none treasury stock is owned by people loyal to Bank of Hawaii.

    3. Share repurchases gets large cash balances off the books which could create problems with various stakeholders: Employees want salary increases; Management wants to buy other companies; and so-forth.

    4. Share repurchases could be the first step of taking a public company private using the companies cash versus an outside shareholder's money.

    Cons:

    1. There could be a better economic use for the cash which is what Alex is arguing. Unfortunately the majority of the cases top level management goes into a buying spree and eventually you have a large conglomerate of several busineses which are completely unrelated to each other. Fast forward and the same conglomeraten starts selling off the companies it purchases - a good example would be GE.

    I am not criticising Alex. I am just presenting a different opinion about share buybacks.

  • Report this Comment On February 24, 2011, at 5:16 AM, TMFAleph1 wrote:

    @Merton123

    Thanks for your comments/ question. On the difference between secular and cyclical markets, here is some good material:

    http://www.taloneight.com/resources/research/SecularMarket.h...

    I like your systematic approach to thinking about share buybacks. If you're not already familiar with it, I think you'll find Michael Mauboussin's framework very useful:

    Clear Thinking About Share Repurchase, Mauboussin on Strategy, Jan. 10, 2006

    http://www.lmcm.com/pdf/ClearThinkingAboutShareRepurchase.pd...

    Alex Dumortier

  • Report this Comment On February 24, 2011, at 9:52 AM, PhulishMortal wrote:

    @truthisntstupid: I almost always enjoy your comments. Even when I don't agree with them, they tend to be well thought out. Have you ever considered hanging up the cook's apron and becoming a contributor to TMF?

  • Report this Comment On February 24, 2011, at 9:59 AM, Brent2223 wrote:

    Don't the low interest rates play into this? Need to dust off the 'ol economics text, but sounds to be that the cost of capital may be cheaper than the cost of equity these days? If so, sounds like management is doing the right thing.

  • Report this Comment On February 24, 2011, at 10:47 AM, daveandrae wrote:

    I had 200 shares of Pfizer stock nine years ago. I had 1,955 shares of Pfizer stock twelve months ago. I have 2,265 shares of Pfizer stock today. On March 1st 2011, when the company pays out its first quarter dividend, I will use that $453.00 dollars to BUYBACK even more Pfizer stock, bringing my grand total to 2,289 shares. The next time I have a surplus of investment capital, I will "buyback" even more.

    Simple, end of story, next subject.

    If you have been reinvesting your dividends over the last twelve months, you haven't been "misallocating" your family's capital. You have been "buying back" stock whether you realized it or not.

    There is no fundamental difference in behavior between the shareholder, and the businesses in which he partly owns.

  • Report this Comment On February 24, 2011, at 11:10 AM, daveandrae wrote:

    @daveandrae

    Where are you getting the earnings for 2011 and 2012? I would find this information VERY useful.

    Based upon your comments it appears that the most logical choice would be to borrow money (at ZERO PERCENT!!!!11111) and use the borrowed money to buy back shares.

    Vidar-

    Google the s&p 500 earnings history. It goes all the way back to 1960. The underlying growth rate speaks for itself.

    As for current interest rates, true story-

    Recently JP Morgan sent me a series of blank checks in the mail. I could use the money in any way I saw fit, as long as I didn't exceed my credit limit.

    The terms?

    ZERO PERCENT for the next 12 months. So yes, right now, if you have excellent credit, banks are literally giving money away.

  • Report this Comment On February 24, 2011, at 12:06 PM, Getnrichr wrote:

    @truthisntstupid

    I'm surprised at the vehemence with which you oppose this article as well as the time spent on refuting it. You seem pretty well informed, but why not offer an opposing view w/out all the vitriol. Anyone worth convincing will likely respond better to a respectfully delivered remonstration, than to belligerent attacks on his intelligence.

  • Report this Comment On February 24, 2011, at 2:14 PM, Merton123 wrote:

    Thankyou for following up on my questions Alex. The two articles mentioned in your post about secular bear markets and Share Buyback were very insightful. Mert

  • Report this Comment On February 24, 2011, at 2:48 PM, TMFHelical wrote:

    Alex,

    So ... when will we see FAS #???? requiring companies to report in their 10K the returns on past share repurchases for period of 10 years or so?

    Well, I can dream anyway.

    TMFHelical

    Home Coverage Fool

  • Report this Comment On February 24, 2011, at 3:15 PM, jaredck wrote:

    @merton123

    I think you are forgetting one benefit of share buybacks, at least from a shareholders perspective versus the alternative of dividend payments is there are taxation benefits for share buybacks...i guess assuming all else equal.

  • Report this Comment On February 24, 2011, at 3:56 PM, racchole wrote:

    @truthisntstupid

    I can't vouch for the accuracy of your statements, but your posts are logical and I agree with you more than those who refute you (which undeniably includes my bias towards Fools.) You can usually tell the intelligence level of an internet commenter based on their overusage of question marks, exclamation points, and capital letters, all of which are found in daveandrae posts. And to compare share buybacks with dividend re-investing? I'm no genius, but clearly these are fundamentally different.

  • Report this Comment On February 24, 2011, at 7:45 PM, FoolTheRest wrote:

    daveandrae,

    It seems Alexandria is listening in...such is the case when proximity is so close to Washington.

    Try to avoid name-calling in your posts. Truthisntstupid probably does not know more than a nine-year shareholder about PFE, but demonstrably more about mathematics.

  • Report this Comment On February 27, 2011, at 6:01 PM, x1x2x3x4444 wrote:

    I imagine a stock buy back is probably better, tax wise, than just giving the money to shareholders. However, I really think all these stock buybacks are nonsense and that the companies should, in fact, just give the money back to investors.

    But as I said, I don't know the tax consequences.

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