Shrinkage vs. Growth

The most interesting story in the history of capital allocation was the rapid growth and then steady shrinking of Teledyne, a conglomerate formed by Henry Singleton in 1960. Teledyne spent the 60’s growing through acquisitions—130 companies in total, bought for twelve times earnings or less—funded in large part by the issuance of new shares of Teledyne stock and debt. One of its last acquisitions in this period was Ryan Aeronautical in 1969—to which we will return. During this acquisitive phase, between 1961 and 1971, sales and earnings grew 244x and 556x alongside large growth in shares outstanding and debt[i]. Earnings were sometimes volatile, but Singleton didn’t care: he focused on cash flow.


teledyne period 1

Singleton grew the company by using expensive Teledyne stock to acquire less expensive businesses. When no more cheap businesses were available, he completely changed his strategy and began cannibalizing his own company. Between 1971 and 1984, he’d become the pioneer of large scale share repurchases. During this second period, sales and earnings still grew, but by just 2.2x and 7.1x. Earnings per share, however, exploded from $8.55 to $353. When it was all said and done, Singleton bought back an extraordinary 90% of Teledyne’s shares[ii].

teledyne period 2

Singleton was a value investor on the way up and on the way down. During his period of acquisitions, he issued shares at an average multiple of 25x earnings (and, as noted, paid less than 12x earnings for the companies he was buying). During the period of massive share repurchases, he paid an average of just 8x earnings for Teledyne’s stock.  The full journey is remarkable: In 1961, Teledyne had 400,000 shares and 13 cents of EPS. In 1984, Teledyne had 900,000 shares and $353(!) of EPS. During Singleton’s reign, Teledyne stock returned more than 20% per year while the S&P 500 returned just 8%[iii].

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In 1999, Teledyne sold Ryan Aeronautical to what is now Northrup Grumman, then in the midst of an acquisitions binge of its own:

http://www.northropgrumman.com/AboutUs/OurHeritage/Pages/default.aspx

http://www.northropgrumman.com/AboutUs/OurHeritage/Pages/default.aspx

At the start of 2005—when its total shares outstanding peaked after 10+ years of large acquisitions—Northrup Grumman had 364MM shares outstanding.

Ever since they’ve embarked on a Singleton-esque reduction of total shares through repurchases. Today they have 181MM shares outstanding, a reduction of about 50%. Over the same period, Northrup’s market cap and net income have roughly doubled (a little more impressive than the overall S&P 500, where total market cap is up about 78% and net income up 58%). Yet over this same period(1/31/2005-2/28/2016), Northrup’s stock is up 460% (16.7%/year) while the S&P 500 is up 124% (7.5%/year).

Why the huge gap in returns, despite growth numbers in the same ballpark? Returns can come from 1) growth of earnings 2) changes in valuation and 3) return of capital to shareholders through dividends and buybacks. Grumman’s earnings have grown, but its P/E ratio is the same today as it was in 2005. The major source of returns has been dividends (straight cash return) and buybacks, which have significantly affected earnings per share. While net income has doubled, earnings per share have almost quadrupled because of the steady reduction in share count.

In the first paragraph of Northrup’s 2015 annual report to shareholders, they highlight the $3.2B spent on repurchases in 2015 and the $4.3B that it is still authorized to repurchase in the future. They, like Singleton, care about cash flows. As they say later in the report, “We believe free cash flow is a useful measure for investors to consider as it represents cash flow the company has available after capital spending to invest for future growth, strengthen the balance sheet and/or return to shareholders through dividends and share repurchases. Free cash flow is a key factor in our planning for and consideration of strategic acquisitions, payment of dividends and stock repurchases.” We don’t know what the future holds for Northrup, but clearly, the significant reduction in share count since 2005 has been a huge part of its total return to shareholders.

These stories are important because while we tend to want growth in all things—from corporate earnings to overall GDP—growth isn’t everything. Often names like Northrup go unnoticed because their sales, earnings, and market caps aren’t growing as fast as the most exciting stocks in the market.

Looking over the same period (2005-2016) for other stocks in the S&P 500, we see a similar trend as we saw with Northrup. The 10% of stocks which have reduced their share counts by the greatest percentage since 2005—stocks like Autozone, Travelers, Coca-Cola Enterprises, AmerisourceBergen, or Fiserv—have done very well as a portfolio. On average, they’ve reduced share count by 47% and they’ve outperformed the S&P 500 by an average of 88%[iv].  What’s interesting is that this strong performance has happened despite the fact the median market cap and net income growth has been lower for these companies than for the average S&P 500 stock.

Buybacks are not a panacea. But used properly, share repurchases can be a powerful tool. Through smart share repruchases (that aren’t simply fueled by debt, and that are performed at cheap prices) companies can produce extremely attractive, decade-long returns for shareholders that surpass their underlying fundamental growth.

[i] The Outsiders by William Thorndike

[ii] IBID

[iii] IBID

[iv] Please note this is a simple, equal weighted average of the returns for these stocks minus the return of the (cap-weighted) S&P 500. Because equal weighting tends to do better, some of this 88% is attributable to the equal-weight phenomenon.