After Friday's column on overpriced share buybacks, I have had several in-depth discussions about the whens and whys of buybacks. I am a loud critic of stock buybacks when they are done at high valuations with no sense of price. Nothing enrages me like seeing a company buy back stock at high prices and then a few years later have to do an equity offering at a lower valuation to raise capital in a difficult economic or sectoral landscape. Unfortunately I have seen that exact scenario play out more than once in my career. Price in relationship to value is important no matter who is paying for the shares -- and all too often corporate CFOs do not appear to do much better than average investors at buying low and selling high.
At the same time, I love buybacks when they are done at attractive prices. Stock buybacks at a discount to book value and very low multiples of earnings have driven much of the strong returns we are seeing as part of the "trade of the decade" in small banks. I have recently purchases shares of several REITs trading for less than net asset value that are buying back shares in the open market. Like many tools, buybacks in and off themselves are neither good nor bad. It is how they are used that determines that status.
I sat down last evening and crunched a bunch of numbers to see what other factors might make buybacks a good idea and offer potentially higher returns to investors. I ran several factors to see which ones worked best in conjunction with a buyback, and as you might imagine, the ones that worked were value factors. While this would seem to be common sense, it is one that has escaped many of the corporate officers charged with managing their company's buybacks.
In one of the more successful tests, we looked for stocks that had not merely announced buybacks but those that had decreased their shares outstanding by at least 5% in the past 12 months. I wanted a quality factor -- as I have seen companies buy back shares while on the steps of bankruptcy, and would prefer to avoid seeing that again. So I only included those with an F-score of 5 or higher. For this test, I limited my search to those that had a rice-to-earnings ratio of 10 or less. I went pretty deep on market cap and included companies as small as $50 million by market cap. I used a one-year holding period for all stock in the test.
The resulting screen of cheap buybacks delivered positive total returns in 12 of the last 15 years and outperformed the S&P 500 in nine of those years. The cumulative outperformance over time is higher, with the model gaining more than 15x the market return. When it does outperform, it does so by a substantial amount, and the returns the first few years after a bear market bottom are spectacular.
This version of the cheap buyback model does not turn up a lot of names each year. The average number of holding per year is 25 -- and that is skewed a bit by the fact that the universe expands dramatically in bear markets. The median number of stocks is 20 over the tested time period.
The number of stocks in the portfolio does give you useful information about market conditions. If there are more than 70 stocks that meet the criteria, it has historically been a wonderful time to be buying stocks. If there are 10 or fewer qualifying stocks, it is a great time to be a seller of stocks. Today there are 13 stocks in the group.
Companies With Large Buyback Programs and Low P/E Ratios
When looking at the spreadsheet of current picks, there are not as many tiny companies as one might expect. The average market cap of the list is $7.3 billion, thanks to the inclusion of large stocks like American Airlines (AAL), Marathon Petroleum (MPC) and Valero Energy (VLO), but the median is still higher than I would expected -- at $2 billion. Fundamental conditions and prospects for the group are outstanding, as the average F-score is 6.7. On average, the companies have decreased their outstanding shares by about 9% in the past year.
Looking for companies that are buying back stocks with low P/E ratios would seem to be a worthwhile exercise. It would be nice if the people executing the buybacks at the corporate level used it as well. Given that there are record numbers of buybacks being executed, I find it a little disconcerting that so few of these companies are doing large buybacks at low prices.