High Conviction Buybacks

Large U.S. companies  spent nearly half a trillion dollars on net buybacks (cash spent on buybacks less cash raised through issuance) during the 12 months ending 6/30/2015.  That’s almost as much as the buyback peak in 2007, which didn’t turn out too well. Scary! But hold on.

Something that gets lost beneath this broader trend is the level of conviction that the companies repurchasing shares have in their own share price. I define conviction as the percentage of shares repurchased by any company over the prior year. Looking at the percentage reduction in shares (heretofore “buyback yield”) is more useful than just looking at raw dollars.

After all, if Apple ($740B market cap) spends $1B on repurchases, its much different than if Marathon Petroleum ($30B market cap) spends $1B on buybacks. Arguably, that billion spent by Marathon would represent a higher conviction from Marathon’s executives in their own share price. They would be making a much bigger bet.

So what if we broke down all the buybacks into three groups by level of conviction. The low conviction group has repurchased between 0 and 5% of their shares in the past year. The higher and highest conviction groups have repurchases between 5-10% and more than 10% of their shares, respectively. When you add up the totals, you see that most of the raw dollars being spent on buybacks come from the low conviction group. Today, the cash spent on buybacks by the low conviction firms is about 70% of the total amount spent. That is very close to the long term average of 67%. 

dollars by convinction buyback group

 

Let’s go one level further down.

Buying back shares at cheap prices is probably a good idea, especially if the company in question has no other promising potential uses of its capital. Conversely, buying back shares at expensive prices is probably a dumb idea. Buffett said something to this effect once, so it must be true.

It turns out that higher conviction buyback programs are conducted at cheaper relative prices, on average.  I evaluate relative prices using an overall valuation percentile, which is just a relative ranking for each stock versus all large U.S. stocks (so the average score is always 50). The percentile is based on four value factors: EBITDA/EV, P/E, P/Sales, and Free Cash Flow/EV.

Here is a time series back to 1987. I’ve also included share issuers here. You can see that on average firms issue shares at higher relative prices.

valuation percentiles by buyback group

More interesting, while low conviction buyback companies buyback shares a little cheaper than the market on average (45th percentile or so across this sample), the higher conviction programs (5+% buybacks) tend to repurchases at much cheaper prices (33rd percentile or so).

Finally, the high conviction companies have gone on to ourperform the average large stock by about 3.3% in the subsequent year, while the low conviction firms haven’t really delivered much excess return at all (just 0.5%, on average).

average forward excess

So, buybacks are popular once again, but most of the cash being spent is being spent by firms repurchasing a smaller percent of their total shares. A much smaller chunk is being spent by firms that are repurchasing a ton of their total shares, sometimes more than 10%. Historically, these higher conviction firms have gone on to deliver pretty impressive excess returns. You can read more here.