Prior to the market hitting a spate of turbulence, for the last four years, I had rarely heard anyone say something bad about a buyback or a special dividend. At that time, I tried to point out (at RealMoney) that buybacks are not costless:
- They reduce financial flexibility.
- They lower credit ratings and can raise overall financing costs, if overdone.
- They can become a crutch for weak management teams that aren’t active enough in looking for organic growth opportunities.
- They often don’t get completed, leading to some disappointment later, after the initial hurrah.
- They can be a clandestine way of compensating employees, because they hide the dilution that occurs from shares received through incentive payments. In a sense, shares are shifted from shareholders to management. Buffett has the right idea here: pay cash bonuses off of exceeding earnings targets. Nothing motivates like cash, there is no dilution, and managers don’t get compensated/punished for expansion/contraction in the P/E multiple.
- A higher regular dividend could be more effective in some cases
- Finally, does management want to make a statement that they don’t see any good incremental opportunities for their business on the horizon? That’s what a large buyback implies.
But after reading a glob of articles criticizing buybacks, it makes me want to take the opposite side of the trade. (Where were these writers during the bull phase?) Buybacks can instill capital discipline, as regular dividends do. A good management team, when considering an acquisition, should at the same time run the same numbers on their own common stock, to see whether the acquisition is an effective way to deploy capital.
The best buybacks are valuation-sensitive. The company has an estimate of its private market value, and the buyback only goes on while at or below that value. When a cheaper opportunity shows up to acquire a block of business, or a new line of business, or a whole business, the buyback stops, and the acquisition is executed.
Much of my thinking here boils down to how good the management team is. A management team of moderate quality should not keep a lot of excess capital around, because they might make a dumb move with it. A high quality management team can run with more excess capital. In one sense, moderate quality managements should shrink their businesses, while high quality managements should try to grow their businesses organically, and through small in-fill acquisitions that enable them to access new countries, markets, products, and technologies cheaply, that they can then grow organically.
There is no simple answer here. Buybacks can be smart or dumb, depending on management talent, what external opportunities exist, and where the private market value of the company is. We can entrust Berky and Assurant with excess capital; it will get used well eventually. Other companies, well, there are some that should keep the capital tight, because the management teams are not good strategic thinkers.
For the less competent management teams, (and, no, you don’t know who you are, that’s part of being less competent), you can look at the problem this way: either you shrink your company through buybacks, or activists will come and try to force you to do it, ejecting you in the process. That may not sound fair, but hey, this is the public equity markets. Sink or swim.
Full disclosure: long AIZ, and a critical admirer of Buffett. Ticker mentioned: BRK/A