Tom Armistead

About the Author Tom Armistead

I'm a well-informed retail investor and post on SA in order to expose my thought process to critical examination and comment from readers. It makes me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that encouraged me to invest very profitably in a rising market. I also did articles on individual stocks, many of which contained insights not available elsewhere. Finally, I wrote a number of thoughtful articles critical of financialism and the lack of ethics on Wall Street. I do not post for compensation, as I am concerned that editorial policy encourages and pays a premium for articles that invite the reader to speculate on the short term movements of microcaps, penny stocks, and controversial issues. The best way for me to monetize my insights is to invest accordingly. As a retail investor, I don't give investment advice. I write about what I'm investing in, and the thought process involved in decision making and stock selection. Hopefully some of what I write is of benefit to others, by sharing my experience as I interpret it and helping them improve their investment thinking and process.

Buybacks: Thoughts On The Analysis Of This Important Use Of Capital

Here ‘s a laundry list of factors to consider when evaluating buybacks:

  • Price paid vs. a conservative estimate of value
  • Historical buyback effectiveness: cumulative price paid vs. current market value
  • Buybacks should be a return of excess capital, after all other necessary or appropriate uses of the funds have been met.
  • Adequacy of spending on capex, R&D, advertising, human resources, debt reduction and acquisitions
  • Appropriate capital structure

Price Paid

Warren Buffett, when explaining the conditions under which Berkshire Hathaway (NYSE:BRK.A) would do buybacks, referred to a multiple of book value, an appropriate metric for insurance operations. The company said in 2012 that it would buy back shares under 120% of book value, after setting a limit of 110% in 2011.

My preferred metric is PE5, consisting of the average of the past four years GAAP EPS and a projection for one year forward. I prefer that buybacks be done at less than 15X on this metric. Alternatively, it’s acceptable if buybacks are done at less than the company’s long term average multiple.

As an example using P/B, consider Chubb (NYSE:CB). Going to Morningstar, they provide a ten year history of P/B. Leaving out 2009, the average multiple is 1.4. Current GAAP BV is $63.87, which when multiplied by 1.4 gives a value of $89.42 per share. Going to the SEC website, I pull up the 10-Q and search on “repurchase,” finding that for the most recent quarter, the company paid an average of $92.95 per share, slightly more than the $89.42 target.

Historical Buyback Effectiveness

Staying with Chubb, while I have the 10-Q open, the balance sheet discloses treasury stock at cost, 131,496,716 shares at a cost of $8,111 million, or $61.68 per share. So with the current market price slightly above $100, cumulative buybacks have created value for shareholders.

IBM’s (NYSE:IBM) buybacks have been the subject of much discussion. A similar exercise finds the company paid an average $122.52 per share for treasury stock, compared to a current market price in the low $160’s.

For something pretty disgusting, ADT (NYSE:ADT) takes the cake. For fiscal 2013, the company bought back 27 million shares for $1.274 billion in borrowed money, at a cost per share of $47.18. Management is either totally inept, or highly skilled, to ring the bell at the top. The 10-K carefully discloses potential conflicts of interest.

The shares recently traded for $35.65, with 23.5% of the float sold short. Of course they are being sued over the buybacks, to include shares repurchased from Corvex Management LP.

Return of Excess Capital

Getting back to IBM, buybacks as a return of excess capital should only occur after capex, R&D, and other balance sheet and income statement investments have been made at an appropriate level.

For openers, capex should exceed depreciation; otherwise, it is likely that plant and equipment will be obsolete and non-competitive. The information is available on the statement of cash flows. Depreciation is typically lumped together with amortization, but if possible the number should be separated. IBM meets this test, after removing amortization which is a separate issue.

R&D as a percentage of revenue would normally remain consistent over a multi-year period. For many businesses, the item makes its way into products or services on a regular basis and a reduction of the expense will mean that customers are receiving less value. IBM meets this test. As an example of a company that doesn’t, Xerox (NYSE:XRX) has shown a consistent decrease, from 3.61% in 2010 to 2.75% TTM.

As a second test, R&D should be compared to competitors. At this point, complexities arise to the extent the businesses aren’t directly comparable, a company with multiple segments may not provide R&D by segment, etc.

Oracle (NYSE:ORCL) spends 13.6% of revenue on R&D, compared to 6.1% for IBM. Comparing the figures would require an understanding of the needs of IBM’s various segments, and their comparability to Oracle.

Adequacy of Spending on Key Items

In addition to R&D and capex, as discussed above, advertising and other income statement investments should be sufficient to stimulate growth. Also, acquisitions and debt reduction should be considered.

Advertising isn’t listed as a separate item on most commonly available formats to present financial information. It will be present in the 10-K, if relevant, and can often be located by a word search. When I looked at Coca-Cola (NYSE:KO), I found that in recent years advertising is 7.0% of revenue, compared to 10.7% in 2005. At this point, questions can be raised: were buybacks done with funds that should have supported operations? Coca-Cola owns 500 brands. Would some of these brands do better if they were advertised appropriately? And so on and so forth.

I was able to raise similar question on Kellog (NYSE:K), and note that management was larding their conference call with references to reinvesting, implying advertising investment had been inadequate in the past.

Appropriate Capital Structure

If a company either incurs or fails to reduce debt in order to repurchase shares, and if the above requirements have been met, the fundamental remaining question has to do with the appropriateness of the capital structure.

Financial Engineering 101 holds that a company’s ideal debt structure will minimize WACC (Weighted Average Cost of Capital). Because borrowed money is cheaper than equity capital, that would imply adding debt until more of it would increase WACC. As a company increases its borrowing, the cost of loans will increase. Also, as the debt load increases, the cost of equity will likewise increase, as the company will be more risky, with a corresponding increase in beta.

This answer creates problems, because it positions the company at a tipping point, where a slowdown in cash flow available to service debt would create difficulty repaying or rolling the debt. It can end badly, with creditors owning the company, or with shareholders diluted by raising equity capital at discounted prices.

Also important, excessive debt reduces financial flexibility. As opportunities to invest become available, if a company is already leveraged to the hilt, it may not be able to respond effectively.

A search of the internet develops the information that the Modigliani-Miller theorem says the debt/equity ratio doesn’t matter. The theorem doesn’t include bankruptcy costs, or opportunity costs.

Forming an Opinion on Debt/Equity

For any given situation, it’s usually possible to come up with an opinion by looking at coverage of fixed charges, the nature of the assets funded by borrowing, the capital intensity of the industry, the stability of cash flow, market yields on the company’s existing debt, the extent to which the debt is laddered, duration matching of assets and liabilities, the presence or absence of credit lines, whether the lines are in use, and any restrictive covenants that may be included.

As an example, IBM has lately been criticized for “loading up on debt” to buy back shares. However, most of the debt has been incurred by an internal financial operation, at a 7:1 ratio, and is supported by loans made to customers. The financial operation is profitable, with a 40% ROE, and at 7:1 is more stable than any of the big banks on Wall St. It’s plain vanilla lending, and disclosed in detail on the 10-K.

From 2009 to 2013, IBM increased its coverage of fixed charges from 11.8 to 13.2. The company is rated AA- by S&P, and debt maturing in 10 years trades to yield 3.298%. Maturities are staggered, with some coming due as late as 2039, 2042, 2045 and 2096.

Similar criticisms were directed at Hewlett-Packard (NYSE:HPQ), back when the stock was heavily shorted by prominent financiers, and traded at what proved to be bargain basement prices. Similar answers could be developed, by investors who preferred to make their own decisions, rather than seek direction from those who talk their book on TV.

A Learning Experience

When the tide goes out, you find out who has been swimming naked.

As an owner of Masco (NYSE:MAS), in early 2009, I found myself holding many shares at a market price of $6, and looking at a spreadsheet that showed the company had repurchased 100 million shares at a cost of $2,857 billion, or $28.57 each. Long term debt stood at $3,915 million, and the precipitous decline in the housing market cast considerable doubt on the company’s ability to repay it.

I held for a bounce to $10, took my loss, and moved on to other investments. I did not neglect to learn a lesson, since I had paid the tuition. Masco was growing by acquisitions, in a cyclical industry, and elected to buy back shares rather than reduce debt. The assets supporting the debt consisted of goodwill.

According to, which measures analysts’ and bloggers’ success rate based on how their calls perform, blogger Tom Armistead has a total average return of +14% and a 69% success rate. Tom Armistead is ranked #573 out of 7391 total experts

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