Buybacks vs. Dividends - McKinsey weighs in

This week the McKinsey Global Institute published a study indicating that most stock buyback programs are value destroyers, in that they tend to buy high and not low.  Their specific example is a technology company that repurchased increasing amounts of shares during the stock market boom into 2008, but then stopped buying shares, even as they plunged during 2008 and 2009.

 

This seems a fitting academic underline of my point about why dividends are better than buybacks: management rarely buys shares at a significant discount to intrinsic value, whereas investors who receive dividends and reinvest them benefit from dollar cost averaging and can also choose to make opportunistic purchases (without an automatic reinvestment plan).

Management faces thre, e hurdles that almost guarantee that it will make poorly timed purchases of its own stock:

·         Management rarely has lots of spare cash when the stock is cheap.  Buybacks require significant free cash flows.  When a company is generating significant free cash flow, however, the market often places a premium on the price of the stock.  The corollary to this is that when markets are weak (and buybacks represent the best value) management usually has better priorities for its funds, including: preserving cash to ensure adequate liquidity in the face of difficult credit conditions, opportunistic acquisitions – everyone else’s stock is cheap, too, after all, and reinvesting in operations when goods, materials and labor are readily available.

·         Timing of buybacks often coincides with option exercises, which are more likely to occur when the price is high.  If the company makes corresponding open market purchases to offset dilution, the company is allowing sellers to pick the timing of the transaction, which is rarely going to work in the buyer’s favor.  Stock buybacks at nearly all firms are partially aimed at eliminating the dilutive effects on EPS that stem from new (or treasury) shares being issued as part of employee compensation.  Naturally, those employees want to exercise their options at a high price, and since multi-year fixed value options offer the holder significant discretion in when to exercise, options are more likely to be converted at cycle highs.

This is one of the most important misalignments of shareholders and management – the classic agency problem options were supposed to fix. When the same management that is selling high for its own account on the one hand is also directing the company’s cash to buy at the same time must be committing the company (and the other shareholders) to buying high.

·         Large scale buying by one investor tends to drive prices higher.  The kind of buyback activity that drives EPS and sometimes share prices higher requires significant acquisition of shares – at least a few percentage points of shares outstanding.  Such significant buying is best done by those who do not have to report their purchases, and who do not move markets.  Companies that pile up their repurchases (say in the run up to the end of the quarter) can become major market participants buying large quantities of shares in bulk and bidding up prices.  Even if management tries to buy opportunistically when share prices are weak, their own buying may eliminate the weakness.  This is good for shareholders in general – ideally share prices would always trade near intrinsic value so that all shareholders would get paid full value when they sold – but it inhibits management’s ability to create value for loyal shareholders.

Given these limitations, I generally agree with McKinsey that managements that want to repurchase stock should do so using a method calculated to minimize the disruption of the markets.   Moreover being sellers themselves they have a fiduciary responsibility not try to steer the purchases of those to whom they are selling – this is sitting on both sides of the table.

Instead, management that wants to repurchase say 25 million shares in the course of a year should simply buy 100000 shares per day on each of the 250 days or so the market is open and trading normally.  If these can be purchased in blocks near market price, fine, if they have to be purchased in lots, also fine.  If this means that the shareholders are not big enough buyers on days when management is exercising lots of options (which expire on the same day) so much the better.  This may lower the spread on the option – so what?

Finally, this raises a question about whether options should be used for compensation at all.  This is another topic, for another post.  Suffice it to say, I am not a fan of incentive programs that turns management into sellers of shares.

Bank shares rally on JPM

This week, we find out about how banks have fared on the stress tests to which they are being subjected by the US treasury.  In an interview a few days ago, Brian Moynihan, CEO of Bank of America indicated that the banks would be shown to be fine, even under extreme conditions (including unemployment of 20% with the related cases of default).



Today JP Morgan demonstrated that they are in the strongest position of all of the US banks by announcing a dividend hike and a massive buyback, equivalent to almost 10% of their market capitalization.  With a payout ratio of 25%, JPM appears to have lots of room to increase the amount of its dividends go forward.

I believe that BAC is in a similar position, even though operational changes have allowed Chase to take over leadership in branches, I firmly believe that BAC is a stronger franchise.  (I cannot believe that I am saying this given that J. Pierpont Morgan is a personal hero).

By 2013 BAC will also be paying a dividend and buying back some of the nearly 11bn shares outstanding.  The stock, which had a nice rally today, will trade at $16-20.  Even with the rally since December, the stock is well positioned to post nice gains over the next 12-24 months.  This is why I am very long the stock, it is by far my largest position.

Some investing wisdom

I haven't had much time to write lately, so I figured I would share some investing wisdom I have come across recently.


Matt Schifrin over at Forbes has written a great synopsis of the investing habits of some extraordianrily successful individual investors.

Jason Trennart raises and interesting argument that successful investing may require less of the technical tools taught in busineses schools and more of the social sciences contextual approach to problems, with the ability to synthesize data of various (and often qualitative) sorts.  Personally,  I believe this is true.  As an historian (undergrad) with an MBA, I can say that while financial skills are important (value is a financial concept), evaluating the risks around the estimate of value often require imprecise contextual thinking.  This is most true in evaluating the managers who hold investors assets in their hands.

Aelph suggests that buy and hold investing is neither dead nor a bad idea.  Admittedly, returns on equity do fall for most businesses over time as it gets harder to redeploy cash generated by the business in initiatives with the ROI of previous investments, but this is an argument for dividends, not an argument against buy and hold.

And a two-for-one: Aelph also has eight rules of investing.  I generally agree with them, though I think he puts too much emphasis on relative valuation, which is a strategy for long-only mutual funds and investment "professionals" who cannot afford to appear to be too passive (especially if the market is rising).  Personally, I believe a real advantage of the individual investor is the luxury of looking at absolute valuation, and mitigating risk by NOT INVESTING when there aren't attractive risk/return opportunities (e.g. US equities in 1999 and 2000).

Finally, I have to give Aelph huge credit for the diligence with which he posts.  I aspire to have that much to contribute.

More evidence of risks investing in China

On the back of lowered Chinese Communist Party targets for economic expansion, the Economist is noticing a series of trends cropping up in China - higher wages, more difficulty adding workforce and above all the need to innovate in order to continue expansion - trends the Strategic Investor suggested as far back as 2007, would begin to manifest themselves in 2012.

How could we be so accurate - simple, we just looked at the simple math of economic expansion (which, despite claims of "miraculous" activity everywhere from West Germany to Korea, is actually quite straightforward).

GDP is simply the product of hours worked and outper per hour.  China faces challenges in both places.  For the past 30 years, China has been able to lift both by increasing workforce participation (by limiting births and time off, keeping women in work) and by employing that labor at higher output factory jobs (albeit labor-intensive ones).  But after decades of low birth rates, the Chinese workforce has finally peaked, which means that unless the Chinese can find a way to keep more older workers in the workforce (tough when many jobs are physically demanding), hours worked is likely to fall.  Of course, if the remaining workers were to work more hours, hours worked could be maintained, but hours worked is not terribly elastic, and if history is any guide, rising incomes will lead to FEWER hours worked, not more, as workers use higher incomes to consume more leisure.

What of higher productivity?  Increasing output per hour is a certainty in China, as the capital stock increases, there will be gains in worker productivity.  These gains will likely be slower, however, because China will have to have better managers to organise the labor around knowledge work, and because success in more cutting edge technologies involves innovation, not duplication.  Here, Communist regimes have a dismal record, which is more or leses echoed by the Economist.  China has few, if any, global brands that are truly home grown.  Lenovo, after all, became famous by purchasing the PC assets of IBM.

China still has many advantages, as do the US, Canada, the UK and Germany.  But as China "catches up" with them and attempts to invade space they now occupy, it will struggle with the limitations of its economic model.  I expect a hard landing in China before the decade is out - possibly as early as 2015.

CL boosts dividend

You heard it here first: CL.  After reviewing CL's 10-K, I predicted that the dividend would rise to $0.62 per quarter from $0.58.  My logic was that this number gets closest to a 50% payout ratio (based on 2011 EPS), without going over.  This is usually the level CL tries to maintain, providing an effective payout ratio in the mid- to upper-40% range (as forward earnings are usually higher than trailing earnings, restructurings notwithstanding).

As I expect earnings around $5.30-$5.40 in 2012, I will predict now that dividends in 2013 will be raised to $0.67 per quarter, for a full year payout of $2.68, with a possibility to skew a bit higher in the event that mangement is able to expand margins (and EPS) faster than I expect.  If management is able to keep repurchasing 20mn shares (gross), then EPS will likely be higher than my anticipated range, since outstanding shares will fall by 3%.

Overall, this represents a dividend growth rate of 7-9% per year plus the 2.5% yield you are collecting.  A very nice and safe 9.5% return in a low return evironment.

Does Crime Pay? Forbes thinks so

One of the best financial magazines ever, Forbes, has always approached the topic of investing and managing money with a low-tax slant and a healthy dose of humor (wealth and happiness are correlated, despite claims of many starving artists to the contrary.  It's just that the correlation is logarithmic). 

Anyway, they are starting a nice series on how crime might indeed pay - the secret is to be a financial "advisor" of any type.  They favor a Ben Graham appraoch - make sure you have fat pitches and high probabilities on the upside and relativel low risk (a margin of safety) on the downside.

I am looking forward to part 2.

CL 10-K Released

One of my favorite days of the year is the date of the release of the Colgate-Palmolive (CL) form 10-K, otherwise known as the Annual Report.  In it, we get to drill into the numbers, and look at the gruesome details of the company's performance.  While much of this information is provided by CL in the earnings announcement in January, the full report is always my basis for evaluating the company, as it is only in the annual report that we can fully understand the changes to the capital account (i.e. how many shares the company handed out in compensation).

Valuation

Let's do the important part first - I think the intrinsic value of CL lies between $95 and $105, with a best guess of around $101.

It is always important to compare the actual results to those of your projections for the company in a DCF.  With some self-congratulation, I was surprisingly accurate, having nailed Net Income (before minority interest) within $4m on a line item of $2554m, about 2/10th of 1% error.  This was achieved with some underestimation of total revenue offset by overestimation of the gross margin the company would achieve.  Several of the operating estimates were quite close, even though they were significantly different from FY2010 results.

As I slightly underestimated depreciation and overestimated capex, actual owner earnings were higher than I anticpated (before minority interest).  Using a discount rate of 8%, which seems fair for such a solid and apparently predictable earnings stream and a terminal growth rate of 2%, We arrive at a PV of $48bn, very close to the current market value of $45bn.  Using a truly fully diluted measure of shares outstanding (which assumes all unvested restricted stock awards and options will be exercised), we have a value of about $95 per share.  One would be tempted at this point to argue that the shares are fully valued, indeed, that they could potentially be somewhat overvalued.

The key variable in my mind is gross margin.  Management has communicated a 65% gross margin target, although, due to price actions in 2011 and commodity costs, margins actually fell in 2011.  The above valuation assumes that margins return to their previous norm of 59%, and growth ticks on at about 6% per year, excluding currency fluctuations.

Were management able to restore margins to 59% and to further expand them, at 0.5% per year over the next decade, falling slightly short of their target, present value would be about $55.5bn, or $110 per share on a truly fully diluted basis (505mn shares outstanding).  These are, to my way of thinking, the main anchor points.  That is, intrinsic value of CL lies between $95 and $105.  So a 3 to 13% gain seems possible, with a nice 2.7% div yield.  One should expect a dividend hike to around 62c per quarter and a price around $101.

Thoughts on management effectiveness

If the Ian Cook era at CL has a theme, it is leverage.  While previous managements have been systematic repurchasers of stock, this management has become downright aggressive.  At first, I thought this was a reaction to a tax code change that required the company to convert the convertible preference stock used to fund the Employee Stock Ownership Plan.  This conversion created 21mn common shares overnight (they had always been there, but were only slowly converted over the previous two decades).  I thus assumed that the step up in repurchases was aimed at keeping the number of shares outstanding relatively stable.  In fact, Cook has continued to repurchase shares at a rate of about 20mn per year (up from 14mn or so under Reuben Mark) and has initiated a significant repurchase program of 50mn shares, which he has indicated he wishes to complete within 2-3 years.

This is no bad thing, provided that he is able to repurchase shares at a discount to intrinsic value.  It appears that CL is doing so, but that discount might be rather small.  What is more likely, however, is that the company has a very high ROE (return on shareholders equity) target.  The single best way to manage the amount of equity is not, sadly, to manage the business, but rather to manage the capital account.  Dividends are a key aspect of CL's investment value for investors, but these are also hard to cut (especially since the company prides itself on paying uninterrupted dividends since 1895 and on raising dividends every year for a half century).  Buybacks offer far more flexibility.

Consider this table (it is my favorite and another reason I always read the annual report).  In it, we see the 10 year development of many key statistics for the company.

The first observation is that Sales On Assets has been pretty stable over time. This means that to grow the business 6% per year, we have to expect assets to grow at about the same rate, thus we can expect that CapEx will continue to exceed depreciation, or there will be some big acquisitions, or the company will stop growing.  Cook has stated that his "funding the growth" initiative is designed to free up the capital to grow from operatoinal efficiencies.

What we also notice is after a very weak point in 2004 (when the company announced a major four year restructuring) there was a steady lift in shareholders equity, book value per share and most important improvement in ROA and ROE.

Since 2008, (the start of Cook's tenure) however, asset effectiveness has been on a bit of a downward trend, and while the company continues to deploy assets quite effectively (earning 19% on assets), there is still concern that the company may be finding it difficult to deploy cash as productively as before.  Part of the issue, when we dig into it, is that the company has made some significant investments in European operations, acquiring GABA and Sanex, major continental brands.  This strengthens the company's market share in Europe, certainly, but as Europe is the geographic market with by far the worst ROA growing there will hurt ROA, unless significant operational synergies or asset dispositions can be found.  (Europe was the laggard even before the acquisition massively boosted identifiable assets of the Europe operation), 

It would be more enjoyable to see further growth and investment in pet nutrition, since this segment earns massive operating profits on assets (about 50%).

The other feature we notice is that assets are being financed with debt, not with equity.  This has the benefit of lower interest rates and boosting ROE (which, as I said, is a key metric in exec compensation) bit it also leaves the company vulnerable to seizures in the credit markets.  Given the remarkably low rates available, however, it is understandable that management wants to aggressively remake the balance sheet.

All in all, CL is a company whose stock I enjoy holding, and whose dividends I enjoy receiving.  I will likely purchase more when I liquidate some winning positions, always taking a part of the gains and converting them into a permanent, rising annuity.

Please note, I can supply a copy of the DCF model I use to anyone who writes.

Dividends vs. Buybacks

One final thought from the Jeremy Siegel article I referenced in my previous post - Siegel equates dividends and stock buybacks.  This is important, because in his quasi-mea culpa, The Future for Investors in which he clarified his view from Stocks for the Long Run, he observed that - geez, much of the return of stocks is actually based on dividends.

Dividends, once upon a time used to offer stock investors higher present yields than bonds, because investors saw dividends as far riskier, since unlike bond covenants, there was no obligation of the company to declare one, whereas bonds had fixed payments according to the covenants in the issues.  The low multiples required to offer 4-7% yields  - normal sums for much of the period Siegel studies, is a big reason why returns have been so strong since 1926, the starting point for the S&P and the oft-cited Ibbotson stock return analysis began.

Dividends today generally still offer lower yields than bonds (though with ultra-low bond yields, dividends are now becoming attractive for income investors).  Nevertheless, few firms yield above 4%, leaving the investor wondering if in fact historical returns are even possible in this market.  The lower yield should cause Siegel to argue for lower earnings expectation go forward.  Instead, Siegel argues that while dividends are lower, companies are instead repurchasing stock, which is also a cash distribution to shareholders and one which drives higher the (tax deferrable) gains in stock prices.  Or does it?

I would argue that the apparent equivalence of dividends and buybacks is a case of sensible accounting misleading investors.  The apparent equivalence is in the accounting treatment of a buyback and a dividend in terms of the effect on the equity account of a company.  On the surface, both moves are a form of cash distribution from the enterprise. This overlooks the fact that a dividend does not direct the use of the shareholder's money, whereas a buyback most certainly does.  Instead of seeing these as alternative strategies for reducing the capital account, dividends should be seen as such, but buybacks should better be seen as investments, because buybacks only make sense if the asset being purchased (the company's own stock) is cheap.

Quick accounting review - when a company declares a dividend, there are the usual credits and debits - the retained earnings, a liability (credit) account, is debited and the dividends payable account - also a liability and credit account is credited.  Debiting a credit account reduces the account, and crediting a credit account increases it, so the net liabilities of the company remain the same, only retained earnings declines and dividends payable increases.  When the dividend is paid, the div payable account is debited and cash, an asset account - a debit account - is credited, reducing both the payable and the cash.

When a buyback is conducted, the capital account - that is, shareholders equity - will aslo be reduced, but in quite a different way.  Retained earnings is not affected (unless there is a subsequent retirement of the shares).  Cash, a debit account is credited, and the offsetting debit comes in the form of a debit to the treasury shares account, a liability and credit account.  The debit makes the treasury shares a negative value on the balance sheet (which you regularly see if you look at a company with large amounts of treasury shares, they are always carried "at cost" as a negative value which reduces equity).

It is no accident that like other investments under the cost method, the value on the books is held at cost.  This is because in actual practice, the company is making an investment in its own income stream.  Buying out other equity partners only makes sense if the value you would pay is less than the future cash flows of the shares that have been repurchased, properly discounted.

Companies should buy their own shares, if and only if, other investment opportunities (in physical plant, acquisitions, etc) are unattractive and the shares are trading at a big discount to intrinsic value.  Buffett, believing the intrinsic value of BH to be much higher than book value, has announced an open buyback of shares when they fall close to book value.  In this way, he is honoring this principle.  If, however, shares are near intrinsic value, a firm should not repurchase, as this will only lead to more selling from investors who believe the cash from the future flows, properly discounted, will not be worth more than the money that had to be laid out to acquire the shares.  If the shares are genuinely overvalued, such as tech stocks in the 1990s, or bank stocks circa 2006, repurchasing does not return cash to shareholders - it destroys value by overpaying for a business (which just happens to be the one the shareholders own).

Ask yourself, if you held a stake in a partnership and one of the other partners offered you a chance to buy part of his stake but you thought the price was outragous, would you feel better if instead of paying from your bank account, you instead used the business' profits to buy him out?   Wouldn't you rather have your share of the profits distributed to you to invest in something else with a more attractive price tag? 

Yet overpaying is effectively what you are doing when you let management overpay for buybacks.  (That they are often the partners whose stake is being acquired should give you pause to question whether your interests as an OPMI and theirs are the same).

This is why one of the first things I look at is the equity accounts - how much stock are people repurchasing and how much are they awarding to themselves.  It is the single best indicator of management's attitude toward shareholders.  One reason I decided to buy Intel stock (and Microsoft for that matter) is that they were significant net repurchasers of stock which I believe was trading at a significant discount to intrinsic value.  Both stocks have increased in price and so I would expect repurchases to be tempered and instead for dividends to be increased at a faster rate.

You could argue that CL, which continues aggressive repurchases with the stock at all time highs, may be making a big mistake.  I concede that this is a possibility, although my own valuation of the stock puts it in low triple digits on the strength of overseas growth, where CL is gaining an increasing share of a market that is growing rapidly along with incomes.

Why the efforts to claim they are equivalent?  At one time, companies argued that it allowed investors to take advantage of tax benefits associated with the deferral of capital gains (and what were lower tax rates on any gains).  Thus it was an attempt to offer shareholders tax efficiency.  Unfortunately, for most small investors, the sums are held in accounts with special tax treatment, such as IRAs or 401(k)s, so the tax advantages are mostly lost on such investors.  In any case this was mostly a cover for a less shareholder friendly strategy.  Repurchasing stock reduces both the equity account (which, all else equal increases ROE), and also has the effect of reducing shares outstanding boosting EPS, changes in which are heavily reported.  it allows management to massage KPIs (and often to produce significant compensation awards for themselves).

For Siegel, a man who supposedly studies valuation, not to focus on this sort of difference is pathetic.  He should be out educating investors about the significant difference between these two concepts, rather than assuming that one form of capital reduction is as good as another.

I highly recommend that if you are really focused on intrinsic value, the biggest single criterion for the evaluation of management is capital allocation, and one of the best metrics available to you is their use of the capital account, particularly as it relates to distributions from the firm.  If they buy back stock in periods of high prices and low, you have to wonder what the real motivation is.

Jeremy Siegel is at it again

It has been said that the only purpose of economic forecasters is to give weathermen a good name.  Nevertheless, making a case for a specific future is a business that seems to pay quite well, and there are apparently enough shameless forecasters (or deluded egotists looking to be annointed with Oracular powers) to keep at it relentlessly.

The famous author of "Stocks for the Long Term" and other books about the benefits of owning equities, and sometime Wharton School professor Jeremy Siegel is out again making market forecasts.  Unsurprisingly, his argument is that the best thing you can do is own stocks.

I don't have a big issue with thesis, but I do take issue with the argument that NOW the market is poised for strong returns.  Siegel seems to believe that the bumpy flatline of 2011 will be replaced with much stronger price performance in 2012.  The argument goes that in studying similar 5 year periods in which stock performance was a bad as that through 2011, the next 18-24 months showed strong gains in stock prices.

This is to substitute reason and logic with statistical correlation, a favorite attitude of several quants, and business school professors in general.  I think it is because their colleages all want to read about their correlation and regression analysis that they think that showing some correlations makes them a brilliant forecaster.

It may be true that the five years through 2011 had low stock market gains.  This is probably also true through 2010, and through 2009, even though 2010 did  not result in strong market performance in 2011.  The fact is, the markets bad performance is mostly attributable to 2007-2009, since March of 2009, the market has done brilliantly, so it is hard to see the whole market as beaten down and vulnerable.

Siegel also seems to disregard economic growth in his analysis, assuming, apparently, that growth is largely constant over time.  What happens if an aging society leads to low growth, a la Europe - or Japan?  Will the surprisingly strong results that were available to investors from 1871, when modern corporations were only just being created, still obtain?  Is it not possible that the growth that underpinned the 8.7% Siegel takes as a given, is in fact a one-time fluke related to the uspurge of productivity a corporation?

For that matter, what would Siegel's numbers look only at US equities, and disregard problemmatic foreign markets.

Finally, Siegel fails to mention the significant and long-term (20 year) periods in which bonds have outperformed stocks.

I do not mean to suggest that the markets might no go up.  I cannot really say how markets will perform.  Moreover, several stocks are still reasonably priced.  But to assume that because some correlations you have done suggset it, is pure crap.

Siegel may be right, the market may have a terrific year, certainly it is off to a strong start.

Aging, Workers and Deflation

This article is really fascinating, even if it is about Canada.

In actual practice, it is about a global phenomenon - lower population - which is going to transform how the world works, plays and above all, retires, over the next several decades.  The short synopsis is that declining family size is shrinking the pool of workers.  This is going to either a) drive up wages b) drive down consumption, c) encourage labor substitution with increasing automation, or d) a combination of all three.

Output looks set to slow its rate of increase, if not to stagnate altogether.  Output is a product of output per hour worked x number of hours worked.  This second factor is itself a product of hours per worker and number of workers.  Thus, output can be thought of as

Output per hour X hours per worker X workers.  If the number of workers declines, then either hours per worker must increase (Stakhanovite sweatshops, anyone?) or output per hour must increase, or output stagnates (one or both of the first two terms must increase just to prevent a decline!)  Since output per hour (productivity) has been increasing smartly over the past several decades, one might think humanity "in the clear".  In fact, rates of productivity growth have generally been declining (prior to the recession anyway) as more and more work moves to services, which are harder to automate and generally less productive anyway.

The effect of this may be to generate a rather extended and continuous DEFLATION.  If demand declines (older folks don't buy as much) increases in purchasing power will come in the form of productivity enhancements driving down prices, a cycle which encourages deferring consumption in favor of lower prices tomorrow.

Wages, of course, may rise to reflect the need for additional workers, but higher wage demands may only accelerate the use of labor saving capital, as prices of finished goods can still decline, compressing margins (and profits).

With more retirees, social insurance programs will also put pressure on worker's wages, as governments look to raise revenue to meet promises to the most reliable voters.

When looking very long term, indeed, even medium term now, that the question of the "new normal" in terms of growth is the biggest question facing investors.  It is by no means certain that the world will return to anything like the rates of growth it has experienced since the Industrial Revolution.  At the end of industrialization may be only modest growth with limited productivity enhancements that can only be generated through massive education investments - and then only pay off decades down the line.