Posted on February 24.
On Tuesday, February 21, 2017, HSBC, Europe’s largest bank, reported a whopping 4th quarter loss of $4.23 billion; a substantially larger loss then the $1.33 billion a year earlier. 2016 revenue, at $48 billion, was 20% lower than the 2015 figure. Seems like an unmitigated disaster, and yet, the Wall Street Journal (February 21) wrote: “There was some good news for investors. HSBC said it would buy back as much as $1 billion in shares, added to $2.5 billion bought back last year …” Judging from the 6.5% HSBC’s share price drop upon the announcement in London, the share buyback wasn’t much of a “good news,” and yet, many companies disappointing investors (and some who don’t) try to sweeten the bitter pill with a buyback. So, what’s in a share buyback? Why and when is it done, and is it good for investors? Lots of confusion about these questions.
Share buybacks are very common, and some are huge: Comcast, for example, raised recently dividends and increased buyback authorization to $12 billion. Goldman Sachs predicts that U.S. companies will spend $780 billion on buybacks in 2017, a 30% rise from 2016 (MarketWatch, 11/22/16). Historically, the percentage of S&P 500 companies buying back their shares rose from 20% in the early 1990s to 65% currently. Back to my questions.
First, why a buyback? Presumed reasons abound: Some finance scholars believe that managers repurchase shares when they perceive the stock to be undervalued. So, in fact, managers exploit a good investment opportunity. A buyback, according to this theory, is a positive signal to investors: buy the undervalued shares and you’ll make lots of money. Which brings to mind Thomas Huxley’s words: “The great tragedy of science is the slaying of a beautiful hypothesis by an ugly fact.” The ugly fact is that research failed to support the “undervalued shares” hypothesis. In many cases, managers buy back shares “high” and later sell “low.”
And then there is the manipulative motive of buybacks: Simply, a share repurchase decreases the number of outstanding shares, thereby mechanically increasing earnings per share (EPS). Gullible investors (there are surely some of those), goes the argument, interpret any EPS increase as indicating performance improvement, and will, therefore, react favorably to a buyback-induced EPS increase. However, the evidence here is clear: buybacks indeed increase EPS, but unless the EPS increase is induced by performance improvement (revenue growth, margin widening), it doesn’t affect shareholder returns. So, while share buybacks to enhance EPS, or to beat the earnings consensus are popular among companies, it’s an exercise in futility, and won’t increase share price.
The only good reason for a buyback is to distribute excess cash to shareholders. Many mature companies with hefty cash flows, like Cisco or Microsoft, accumulate huge amounts of cash which, absent attractive investment opportunities, should be distributed to owners. Buybacks are, in fact, dividends, but they are preferred by managers because they don’t signal the promise of recurrence embedded in regular dividends. So, share buybacks, in fact, signal bad news: the growth period is over, since there are no more attractive investment opportunities to fund with the cash. Recent research indeed shows that buyback companies perform worse and their share prices lag behind companies which don’t repurchase their shares. But at least, buyback mangers aren’t wasting your money on useless M&As. A consolation.
Lessons to investors: Don’t be fooled by an EPS increase induced by a share buyback. It won’t enhance share price. To adjust for a buyback impact on EPS, calculate the periodic EPS change by computing current EPS with the number of shares outstanding last period (i.e., holding the number of shares constant), or just consider the change in total earnings. Relatedly, a share buyback announced with a disappointing performance, like my opening example, doesn’t really sweeten the bitter pill. The only good news in a buyback is that it leaves less money for managers to squander. Importantly, investing in companies that buyback their shares won’t get you much. And finally, if you think you know everything about buyback shenanigans, think again: many companies announcing with great fanfare large buybacks don’t deliver on the promise. Over time, actual share repurchases often fall short of the promise. But, hey, managers know that most investors don’t look back.