Turning once again to buybacks, I continue to look for what conditions make it a smart idea to buy back stock. As opposed as I am to stock repurchases at high valuations that waste cash, destroy long-term shareholder value and come with a high economic and social cost, I am a big cheerleader for buybacks done at price and valuation levels that increase returns for shareholders and add value to the company.
I have looked at dozens of variables and narrowed the list down to a handful of characteristics that define a smart stock buyback.
Today I want to look at buybacks done when the EV/EBIT (enterprise value/earnings before interest and tax) ratio is 10 or less. EV/EBIT is one of the key measurements in the private equity toolbox, and it makes sense that we use it as well. Once again, I limited my search to those stocks that are at least $50 million in market cap and to ensure some measure of financial quality only considered those stocks with an F-score of 5 or higher. To make the final cut, the company had to have reduced the total share count by 5% or more over the past year.
This buyback portfolio does very well over the long run. It outperforms in both up and down markets, but the down market defense is its most outstanding feature. The model portfolio has positive returns in 14 of the past 17 years and outperforms the market itself in nine of the 17-year time period, so like many value strategies it takes discipline and confidence to stay the course when it lags the S&P 500. In bad markets, the portfolio holds up much better than the market, and outperforms by a substantial margin in the first couple of years after the market bottoms. When it does lag, it is usually falling a few percentage points behind a fast-rising market, so the pain is more that of gaining less rather than suffering larger losses.
The average number of stocks helped by this approach is 56 per year, but once again the average is kinked a bit, because the number of candidates explodes when the market falls. The median number of stocks since January 1999 in the portfolio in a given year is 47. There doesn't seem to be any useful information about the relative over valuation of the market in the data, but if the total number of candidates to buy reaches triple digits, it is time to buy, and buy aggressively. The 100-plus stock years were 2000, 2006 and 2008, which were what Charlie Munger might call times of extraordinary opportunity.
The current portfolio consist of 36 stocks. The average market capitalization is $6.7 billion, so this not one of Melvin's micro-cap portfolios by any stretch of the imagination. The average F-score is 6.8, so the EV/EBIT buyback portfolio consists of financially solid companies with improving fundamentals and prospects. The average EV/EBIT ratios is just 7.2, so you're getting, and the companies are buying shares back at, bargain price levels. On average, share counts have been reduced by 8.65%, so the boards of these companies are being smart about repurchasing their shares when they represent an attractive price relative to the value of the company.
The five biggest stocks on the current list are Boeing (BA), Valero (VLO), American Airlines (AAL), Marathon Petroleum (MPC) and Hartford Financial Services (HIG). The five cheapest based on their EV/EBIT are Northeast Bancorp (NBN), Outerwall (OUTR), World Acceptance(WRLD), Visteon (VC) and GameStop (GME).
Taking a step away form the quantitative data to insert a qualitative observation, 21% of the portfolio is in community bank stocks, once again reinforcing the idea that these stocks belong in your portfolio today. They may not be in the headlines or have the excitement of owning today's tech leader, but they are cheap and management at many of these institutions are doing what they can to enhance value and reward shareholders. Those who are buying back stock at low levels of assets, cash flows and earnings, should be among the leaders of the trade of the decade.
The EV/EBIT ratio is used by private equity firms and LBO buyers to determine the valuation level of a company. I have long been an advocate of outside investors using this valuation measure, and it makes a great deal of sense for corporate CFOs to incorporate it when timing their stock buybacks. Buying back stock at low enterprise multiples is a winning strategy, and builds a great deal of value for shareholders.