Motley Fool Answers' July Mailbag: How Do Share Buybacks Work, and Are They a Good Thing?

If there's one thing Motley Fool Answers hosts Alison Southwick and Robert Brokamp enjoy, it's hearing from their listeners, so they particularly relish the monthly mailbag episode. But even they can be overwhelmed by the quantity and breadth of those queries, so this time around, they've invited a couple of friends to help out: serial podcast guest Jason Moser and Answers newbie Abi Malin.

In this segment, they dive deep into the mechanics, economics, and philosophy of stock repurchases.

A full transcript follows the video.

This video was recorded on July 31, 2018.

Alison Southwick: Our next question comes from a couple of people. Alex Lindblad sent the question over Twitter and then Brian sent a similar question over email. Before we get to Brian's question, let's start with Alex over on Twitter. Alex wants to know if we could explain the mechanics of share buybacks. Does the company buy on the open market? Do they buy it from private firms? Are the shares no longer available to the public?

Jason Moser: A couple of things. Typically you'll see shares bought back either via tender offer which is where they put out an announcement to shareholders saying they'll buy back shares from them or they'll go on the open market and purchase those shares. A lot of times those repurchases will cancel those shares outright. Sometimes, though, those shares will go into what's called "treasury shares", where a company's not cancelling them, but basically putting them in reserve in case they want to use them later on for compensation or if they want to reissue shares for some other reason like a dividend or what not.

Now, when a share is in treasury, it's not calculated in earnings-per-share figures or dividends or voting rights. They're kind of sitting there on the bench like a lot of the guys on a football team. You've got 11 guys on the field and you've probably got 40 of them sitting on the bench. They're in reserve.

Southwick: Everybody gets a Super Bowl ring, though.

Moser: Exactly. Those are the general mechanics of buybacks.

Southwick: Let's move on to address Brian's question, which gets into it a little bit more. "What should I think about a company spending cash on buybacks? Buybacks decrease share count which means every share I have is a slightly larger piece of the company and it means EPS goes up because there are fewer shares to divide the earnings by, but my shares are a slightly larger piece of a company with fewer assets. Shouldn't the plus of fewer shares and the minus of less cash cancel each other out?

"Furthermore, some companies seems to make questionable decisions regarding buybacks. McDonald's took on increased debt and spent more than their cash flow on buybacks. It appears to have worked out for them, but it was a risky move and could have gone wrong. Micron issued stock at a low price and now is buying back at a high price, which sounds like a questionable idea.

"I'm also very curious about whether the velocity of money in an economy is slowed by instituting buybacks instead of investing in capital improvements, research and development, higher wages, or even dividends. Some people are dismayed that so much money from tax cuts is going into buybacks instead of moving around in the economy. SEC Rule 10b-18 is actually controversial, although I've never heard of it until recently."

Southwick: Well, Ron, I'd never heard of it until you just said it.

Robert Brokamp: I'll start by talking about that. That was passed in 1982. Before then, stock buybacks were considered possibly illegal because it was basically seen as a company trying to manipulate its stock price, which frankly it kind of is. Then that got passed and then stock buybacks started to soar. In 1997 companies began spending more money on buybacks than they do on dividends. That's that for that rule, but I'll let Jason take the rest of this.

Moser: I feel like we could have an entire podcast just to talk about this topic, alone. It is one that generates a lot of conversation. We talk a lot about buybacks in conjunction with dividends. Dividends are cash in the pocket and buybacks are kind of theoretical. You made the point that if you buy shares back, you should in theory lower the number of shares outstanding which would make your shares worth more. That's assuming that the company is not issuing more shares to pay for compensation or whatever.

So the first thing is whenever I look at buybacks, if I see a company that makes a lot of stock buybacks, I'm going to look on their balance sheet over time and look at the actual shares outstanding, because if I see where that shares outstanding count is either flat or going up in the face of doing buybacks, then I've got a real problem with that. You're not doing me any favors by buying back shares. You should either be giving that money to investors in the form of a dividend or reinvesting it in the business, and if you feel like you can't reinvest it in the business maybe you're not the right leader for the business in the first place.

Now, with the recent tax legislation I think buybacks have become more of a point of controversy because they're seen as helping out Wall Street while not really helping out Main Street. Now, I would argue that maybe Main Street should be a little bit more invested and then at least you're being a part of that process and you're benefiting from it in some way, shape, or form.

When it comes to buybacks, there's some great FactSet data out there and I've used this in a number of Fool presentations before. It goes back a number of years. It shows without question how many companies get share buybacks wrong. And what I mean by that is they tend to buy back shares in times when markets are going up. When everything is hunky dory and your share price is through the roof, management's adding to that fire by saying, "We're feeling so good about things, we're buying back more of our shares because everything is great."

Really, they should be buying back their shares when we want to buy their shares on the cheap. But it's clearly, through this data, shown that when the market starts declining when share prices go down, these management teams then cease those buybacks. They stop buying back shares. So most management teams out there actually get it wrong. Every once in a while, you find management companies out there that do a pretty good job of it.

I think there are a few signs to look for there. First and foremost, take a look at the balance sheet. Make sure that share count is actually going down. Did they issue a dividend? Could they issue a dividend instead? They talk about it a lot in the conference calls. There's just a lot of different ways to go with it. You can't use a blanket statement and just say they're good or bad. It is very company-specific, but that FactSet data shows very clearly that of all of the S&P 500 companies, a lot of them really do get it wrong.

Brokamp: According to The Wall Street Journal, this year the companies in the S&P 500 are on record to buy back more than $800 billion worth of stock, which would be a record. The previous record was something like $560 million in 2007, which of course was right before the Great Recession and the stock market dropped by more than 0.5%.

There is certainly evidence of people getting it wrong. They buy back their shares at the wrong time. What they would say to you today is where else am I going to put it? Warren Buffett and Berkshire Hathaway came out with different guidance, recently, about when they'll buy back their shares which people took as a hint that maybe even they'll start doing more of it, because there's just not that many other great opportunities out there.

Moser: And that's a really interesting point, there, because also with Berkshire Hathaway for a very long time... I mean a lot of investors asked, "When are you going to start paying a dividend?" The standard answer has been, "Well, we feel like we can do more with that capital on your behalf as opposed to just giving it to you in the form of a cash dividend." I think at this point, when they announced that they raised that threshold for buying back their own shares, I've got to believe that question is only going to become louder among the investing community. Why not just give us a dividend now, if you feel like you're running out of places to put that cash?