Capital Allocation Part 1: Creating Value via Share Repurchases

Conventional wisdom says that share buybacks, when done appropriately, put money in shareholders' hands, since a reduced share count means an increase in earnings per common share. Yet, as is often the case with Wall Street and many corporate chiefs, this view is long on convention and short on wisdom.

First let's get some facts straight. Share buybacks are only a prudent use of capital when they represent the best possible alternative to other sources of capital. So, for example, a company loaded down with high-rate debt would probably do better using excess cash to pay off the debt, rather than using it to buy back stock. And if a company is blindly buying back stock at any price to soak up share dilution caused by excessive issuance of stock options, buybacks aren't effective. In fact, they can destroy value if the company is buying high.

On the other hand, at times it can be prudent for a company to take on low-cost debt and use the proceeds to buy back stock that is generating a greater return than the cost of that debt. These are capital-allocation decisions, and most managers are good at managing -- but not so good at allocating the capital.

Another prudent time for companies to buy back stock is when they are applying the first lesson learned in Investing 101: buying low and selling high. Good capital allocators do this habitually. As Buffett quips, "Why try to jump over seven-foot hurdles when you can walk over one-foot hurdles?" Company insiders (hopefully) know more about their business than just about anyone else, so when the opportunity presents itself to invest in their own backyards at cheap prices, why would they go looking at more difficult opportunities?

Most insiders know their company better than anyone, so when their company's shares are cheap, and no other investment opportunities exist that are superior from a risk/reward standpoint, then they will back up the truck. Homebuilder NVR (NYSE: NVR  ) , under Chairman and CEO Dwight Schar, has done a magnificent job of using share buybacks to truly create shareholder value. Since 1997, NVR's shares outstanding have declined by more than 50%, to just above 5 million today. The gradual buyback of stock created tremendous value for NVR shareholders. Excluding the current housing slump, NVR was cranking out ever-increasing profits over a reduced share count, a double whammy for investors.

In 2002, the company's net income was $331 million with around 7 million shares outstanding; by 2006, profits were $587 million with 5.6 million shares outstanding. Even with the decline in profits in 2007 to $334 million, NVR's share count declined as well, to just over 5 million -- resulting in respectable earnings per share of about $54. This seems to have worked well for NVR, even through a weakened housing market, and the company is holding up nicely relative to the likes of Hovnanian (NYSE: HOV  ) , D.R. Horton (NYSE: DHI  ) , and Beazer (NYSE: BZH  ) .

All aboard the value train
NVR is one sound example of creating value via share buybacks. Another great example is railroad operator Burlington Northern (NYSE: BNI  ) . Since 1996, Burlington has reduced share count by nearly 25%, from 456 million to around 355 million today. During most of these years, share prices ranged from the mid $20s to the high $40s. Today, the stock fetches almost $90 a share. Were these buybacks a prudent use of capital? You bet. Is it coincidence that Warren Buffett's Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) now owns more than 15% of the company? I think not. Buffett realizes that good CEOs who also happen to be good capital allocators are a rare breed on Wall Street. So when Buffett finds such individuals at companies that he understands, he doesn't waste time allocating his capital.

Sometimes good, sometimes bad
As with any investing school of thought, share buybacks are not automatic value creators. In the piece to follow this one, I will illustrate how Wall Street banks, in their infinite wisdom, managed to perfect the art of buying high and selling low. Prudent buybacks can create tremendous value for patient investors, but buying back shares only to sell them off at lower prices leads to a tremendous erosion of wealth.

Get a great deal on more value-creating Foolishness:


Read/Post Comments (0) | Recommend This Article (7)

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.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 577145, ~/Articles/ArticleHandler.aspx, 10/23/2014 5:40:10 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement