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Welcome to Investing for Beginners podcast this is episode 67. tonight Andrew and I are going to talk about share buybacks, this has been a hot topic on Wall Street lately and Andrew and I wanted to do a little deep dive into share buybacks and talk a little 101 about how they work what they are and how they can benefit the company and you.

Without any further ado I’m going to turn over to my friend Andrew and he’s going to start us off.

Andrew: yeah love it. I feel like it was meant to be right well media talking all about buybacks obviously a big impact from the tax cuts that Trump did. So it’s very timely and it’s also good segue from last week’s topic. so if you remember last week we talked about owners earnings and how that can be a better way to kind of calculate how a company is using not only what’s the company earning from the core business whether its profits.

But also how is it allocating those profits once it has once the company has that earnings so owners earnings is a way to do that and one way that companies allocate cash once they receive those profits is through share buybacks and so that’s what we’re going to cover today.

You’ll hear called several different things share repurchases stock buybacks share buybacks it’s all referring to the same thing. So if we really get down to like the base route of what share buybacks is it’s simply the company taking cash and buying back shares.

What that means is they’re reducing the shares outstanding what that does for investors who already own the stock is it pushes everything up so it will push the market cap up because the company is buying these shares it’s going to push the price up right so I’m sorry the market cap stays the same the price goes up because the shares go down and then you also get anything that’s valued on the per share basis will go up so earnings per share arguably Wall Street’s biggest focus that goes up because now you have less shares and book value per share goes up cash per share goes up all those things go up.

And so Wall Street tends to like share buybacks and it’s kind of debatable whether it’s good or not for a company it’s very contextual but before we get too deep into like the concepts between whether it’s good or bad or whether it’s optimal I want to share a couple of articles that I’ve seen that are recent about share buybacks and so one of them here is talking about this is July 10th recording this end of July.

Tax cut triggers 437 billion dollar explosion of stock buybacks so there’s I feel like a general misunderstanding in the public of share buybacks and how they impact a company. Because a lot of I don’t want to get political but a lot of the critics of the tax cuts they will argue that the tax cuts are only tax cuts for the wealthy and they will also say that workers are not being benefited by it.

I think we do need to address those things because there’s no doubt that once you understand how the stock market works how stocks work that share buybacks are almost all the time great for investors great for the people involved in the company and it’s great for the economy overall.

If we can understand some of the more intricate details of share buybacks then we can understand exactly why that is the case so you have to think first off when we’re talking about the wealthy it is true they say the top and this is coming from the this article from CNN. The top 10% of households owned 84% of the stocks in 2016.

What you have to understand is that’s more of a byproduct of a capitalist society if you want to have small business owners what’s the draw for a small business owner to open the business? If they let’s say open the pizza shop and they have to hire ten employees in order to run the pizza shop the small business entrepreneur needs to take on a bunch of risk he needs to raise capital he needs to pay for pizza supplies he’s got to pay for the marketing advertising he needs to pay for the rent to keep his pizza place open he’s got to buy furniture he’s got to buy ovens.

All of these things are something that the pizza owner is going to do if a pizza store on there if he’s not getting a hundred percent of if he’s not getting a significant part of the profits for opening this pizza store there’s not a good chance that he’s going to take all this upfront financial risk not to mention all the time spent right.

Say for example that he’s not owning a like a large percentage of his company like a lot of the top 10% of households do. So say he’s able to run a successful pizza business but he’s only getting like a 20% take of the profits he probably can’t support himself on something and as such as humble scale as like a local pizza shop. So like there’s no win-win for him yet he has a ton of downside and not much upside.

But in the capitalist society he can start the business take on all the risk himself and have a hundred percent equity of his business which means he gets a hundred percent 100 percent claim of the profits of the business and now allow him to support himself and possibly grow maybe have another pizza shop and be able to hire more workers that way.

One last thing I’ll say is guys like Buffett and Gates these are really some of the people that they’re talking about when they when they talk about the top 10% of households who owned a disparate disproportionate amount of the wealth in the United States.

They have been people who like founded their businesses or been big impacts right like Bill Gates built Microsoft Warren Buffett built Berkshire essentially rescuing it from this floundering little textile business and making it into a huge conglomerate that buys businesses and there’s an insurance Titan and the is able to allocate capital really well by making good acquisitions.

They so they are the other by-product right so if you’re going to let the pizza shop on their own a big portion of the equity in the profits then also the people who work to make these businesses so big these life-changing businesses the ones that serve so many people then that’s like the other side of it.

I recently read a book just finishing up I might have mentioned this book already Tap Dancing to Work it’s talking about a good summary of a lot of the stuff that’s been written by Buffett in magazines like fortune and one of his big things in like 2010 time period was this movement to get a lot of the billionaires in the United States to pledge a big portion of their net worth so they’re there him and Bill Gates they were really a part of this movement to get billionaires to play over 50% of their net worth to charities and to philanthropy.

And so they were actually pretty successful at that they had a good group of people and really starting this movement of doing less of giving a bunch of money to your kids and instead doing it philanthropy and a philanthropy to really benefit society. And so there is a lot what is the way that they’re doing that they are doing that by giving up some of their ownership.

so Buffett gives a way I think is somewhere between 4 to 6 percent of his Berkshire shares towards charity every year stock buybacks increase the value of those Berkshire shares so really he’s helping  these share buybacks are kind of being very fruitful when it comes to the overall economy when it comes to society in general and I think that’s something that’s not really I get it like I didn’t know this stuff until I really started studying finance and studying the stock market studying these great investors.

The more you study about how the business world works how capitalism works how the economy works then you start to get better insight on share buybacks. so that’s some of the good parts of share buybacks and I’m not even talking about how workers benefit through stock options and things of that nature what are some of the downsides to share buybacks and that maybe I’ll have you Dave chime in on your idea of if we talked about some of the benefits to the economy and to business in general when it comes to share buybacks.

What are some of the potential negative consequences of share buybacks?

Dave: well the first one that pops to mind is the one of the reasons why you would do share buybacks is it you don’t really have any other option to use your money for. And so you can either use them there’s basically three different ways you can use your money when you have cash left over at the end of the month year however you do it.

Is you can reinvest back into your company so buying more assets to grow your business make more money with which we’ve talked about before. You can also use it to issue dividends so paying us investors back for investing in the company and the other option is doing share buybacks.

So one of the ways when you’re doing share buyback so that it could backfire or be a bad thing is if you’re buying the company at a premium to the intrinsic value. So just to use easy simple numbers let’s say that the intrinsic value of the company is $50 but the company is selling for $100 currently. Then if you buy your shares back at $100 it’s yours you’re basically paying more for like what the company is actually worth.

And so in essence you’re I want to say throwing your money away but you kind of throw in a money away and in that circumstance it would have been better to not do a buyback because really all you’re doing is reducing the amount of shares which obviously is in the short termism which is one of the criticisms of doing buybacks. Is it can as Andrew was saying earlier earnings per share is a very big focus on Wall Street and if you do share buybacks the average person is just going to notice that hey  JPMorgan went up by their shares went up by almost a dollar 50 over the last quarter that’s awesome.

But if they don’t look back and see that there was actually share buybacks and there was a dilution of the shares then that’s what really caused it to jump up. regardless of all the other financial factors that are going on with the company at a time it could have been a negative thing for them to do in the long run and so that’s where doing something like this because  we’re not talking about  pennies and dollars here we’re talking millions of dollars here that are being exchanged.

And so if you pull the trigger and you buy back shares of your company at a time where it’s overvalued and then six months a year two years down the road when you could have used that money to buy more assets to build your business then that would be a negative thing for the company for sure.

And that’s to me those are the two things when I’ve read about buybacks those have been the two negative things that I’ve come across is the over valuation of companies and with the stock market being as heated it has been over the last four or five years with the naysayers we’re in for a another crash any time here and in their future everything’s overheated like that.

You’re going to be buying shares that are overpriced and that’s more of a bad use of money and I guess one of the things that I would segue a little bit off of that is Warren Buffett talks a lot about share buybacks and he’s asked that question all the time.

Because he as we’ve said before does not issue a dividend and so one of the ways really the only two ways that he can pay us back are either doing share buybacks or the share price increasing and so obviously his share price has increased even since four years ago it’s gone from $95 to $198 so that’s a huge increase which is awesome.

But he’s also sitting on a hundred and five billion dollars right now and so there’s been a lot of criticism about him about what is the with his money. And so there was a recent news article that said that he announced their board announced that their changed the rules for their company on what they would consider doing share buybacks. And I will put a link to that article in our show notes so if you want to read more about that.

I won’t go into all the technical details that he was talking about but it was good news for the company because that means that he’s opening up his the opportunity because he feels like his company right now is undervalued. And so buying those shares back would be a boon for the investors because it would raise the price it would help raise the price it would help reining raise the earnings per share and all the financial metrics associated with that would improve quite a bit.

That’s big news in his world because his opportunity for that hundred and five billion is because he feels like things are so overvalued right now he hasn’t had a lot of opportunities to buy other companies which is his really means of buying assets.

And I guess those are some of my thoughts on maybe the negativity of possible buybacks your thoughts?

Andrew: oh that’s exactly it think I haven’t checked it lately but I believe Berkshire still has a decently low price to book ratio so it does  makes sense that’s probably another factor like you said. For one the acquisition prices are probably very high you’ll tend to see  if prices are high in the stock market you can bet other companies are going to want high prices as well if they’re trying to sell their businesses outright and something like an acquisition or a merger.

And the other factor probably being Berkshire not being terribly expensive considering all the businesses that they own.

Dave: yep so taking a real quick look at Berkshire why Andrew was talking about that their book value per share right now is currently a little over $140 and the share price is trading at 188.47 so according to Buffett’s calculation the way he looks at intrinsic value the company is undervalued and the price-to-book ratio which Andrew and I’ve talked about before in the past is sitting at a 1.41 which is a nice number to look at as well so that would also indicate that it’s probably undervalued as well.

Andrew: I think that’s about half of what the general S&P; if not less than half what the SPS trading as far as a price-to-book ratio it’s somewhere in that range.

You have to think on the one side Buffett’s going in and buying back his shares of his company because it’s undervalued it’s a good deal for shareholders and on the other side kind of going circling back to what they’ve said if you really think about imagine a company you had a bunch of cash in like 1999 during the bubble and they used a bunch of that cash to buy back shares.

You’re all that that’s really doing is just perpetrating the bubble and so if the if the price of your stocks already at such an unsustainable high level that we’re talking about bubble levels. We’ve seen bubbles in the past and I’m sure we’ll see bubbles in the future. where that price got so high and then it will pop and never recover.

Definitely in the dot-com boom you saw that with some of these tech companies and so from a shareholder perspective from an owner perspective using buybacks in that way is not a good way to go because that is throwing away money. If the share price never recovers you really paid a ton you way overpaid for the idea to lessen the shares outstanding.

There’s a couple other kind of details I think we can cover about so I guess we covered the generalities of positives we covered the negatives. I’ll add on another positive and see what you think they’ve the when you look at like the lifecycle of a business when you look at like a core business like let’s take I’m not saying anything about the company or the way that if they’re doing buybacks or what.

But let’s say like a company like Facebook they the growth of their business will depend on how much they can monetize each customer that has a Facebook account and then secondly how many customers I can get to have Facebook accounts.

We have to understand at a certain point the number of people in the world is limited sure like you’ll have population growth but the growth will really slow compared to when they were first starting now maybe they just had a small market share percentage in the US and then you compare that to already being so big that they’re at a global scale that spending more money on advertising wouldn’t give you more customers just because they’re ready they’ve already reached the whole world number of customers.

So going back to like a positive of share buybacks that would be an example where reinvesting in the business trying to get more customers would not be as efficient with the cash then maybe giving them back to shareholders. Because not only do share price tends to go up because the shares.

We already covered that like the Wall Street likes share buybacks tends to push the stock price up good for investors and shareholders in the business another example would be like Buffets M&A in a situation where companies are really asking too much to be sold and so you can’t you don’t really want to waste cash in that way to make expensive acquisitions.

And so it’s something that comes with context in every situation will be different every stock every company and depending on the market environment it’s going to be different to what scale you want to see share buybacks if a company if a company’s core business is close to that saturation of growth point. Then maybe that’s the time to buy back more shares.

The other kind of third factor that we haven’t talked about yet is dividends and so you can reinvest in the business you can buy back shares or you can pay a dividend.

I think it’s kind of clear that if there’s no good reinvestment opportunities or the reinvestment opportunities are limited you don’t want to put too much capital on it if the share price itself is very expensive right if it’s overvalued compared to its true intrinsic value maybe share buybacks aren’t a good thing to go for in that case. so the last kind of logical thing besides leaving it and just accumulating cash kind of like apples done they’ve just accumulate a large cash balance but the other alternative would be to give it back to shareholders in the form of a dividend.

and they kind of don’t want to say maddens me but it it’s disappointing to see that a lot of corporations aren’t doing this as well as they used to and I don’t know if it’s because investors aren’t standing up for themselves in the sense they’re not voting with their dollars.

But the average dividend yield and the sp500 has been dropping for the past 20 years and when you compare it to previous time periods like the 70’s 80’s even back to like the 20’s and 30’s we’re seeing the steadily draw a steady drop in the percentage of dividend yield being paid out to shareholders. And so how is that cash being used it’s if it’s if there’s no efficient way to grow the intrinsic value of the business then give it back to the shareholders.

They can then take that dividend and reinvest it themselves and so they will see guaranteed returns they will see their own ownership grow right when share when the shares outstanding shrinks because of a buyback every shareholder now owns a larger part of the company because there’s less shares outstanding. The same is true on the dividend because the investors can just simply reinvest in the business and have more shares outstanding then that gives them a greater percentage of part ownership as well.

So while I don’t I don’t have a black-and-white view on buybacks versus dividends. I believe there should be a healthy balance of all three components but I’m maybe out on my own on an island when I say that I think dividends need to be given more attention than they are and I think they need to be prioritized more than they are when it comes to distributing cash back to shareholders.

Because one of the big things for me is that the performance of businesses will be very up and down its rocky it’s never smooth and consistent. You might have years where a company has a ton of cash and so they buy back a bunch of shares and then in two years they could run into some troubles and have to dilute shares to they will have to dilute shares to raise cash to survive the tougher times.

What you really have is just a bunch of cash and shares kind of moving up and down and so over a five-year ten-year time period what happens if you buy back shares and then dilute stock and buy back shares and dilute stock well the shareholder is just constant.

Really that cash was a complete waste and he didn’t receive any of it when you contrast that to a dividend you’re getting that dividend payment every time so even though the company can play with their shares outstanding the number of shares you personally own will always be increasing so you you’re going to expect over five ten twenty years that the shares outstanding is going to jump around.

But if yours is steadily increasing you’re getting compound interest no matter what that means you actually got some of the profits that happened during the boom times and then believed in the company to sustain as during the bad times. So that’s kind of why I really wish dividends were given more consideration than buybacks.

But it does also have a very great utility in the stock market for all the reasons we talked about and if there’s a healthy balance as long as shareholders are getting a decent dividend then I think if shares are undervalued that they should also be doing share buybacks and it’s really up to management and not there’s no quantitative number that or no formula that can tell us if they really did a good job it’s it’s going to be based on their judgment what opportunities they have out there.

But you can tend to see if a company has a good track record if they’re doing well if management’s been competent up to now then you can only hope for the best and hope that they can continue it. But the bottom line really is company will make their earnings they will have or EBITDA like we talked about last week they will have profits that they need to figure out what to do with.

The three ways they probably can do it is share buybacks reinvesting the business and dividends or just holding the cash there needs to be a healthy balance of both once you understand everything and kind of digest what we talked about today you now understand that one component of share buybacks and why it’s good when it’s not and how it affects shareholders.

So when you read those articles that you see online where they talk about buybacks and what that’s doing in the economy and how much these companies are spending on buybacks that are not throwing the money away it’s going to shareholders it’s going to anybody who has a retirement account anybody any pension fund that invests in mutual funds and index funds anybody that’s related to stock market anyway. It is more often than not benefiting them and for all the reasons we discussed that is why.

Dave: I agree that’s a those are great points and I don’t think I really have much darky with about that I agree with all the things you’re saying I think that the move away from dividends and the move towards buybacks in the long run I don’t think it helps the investor and I think that’s one of the things that I would like to see them get back to and why that’s happened I don’t I don’t know that I have the answer that maybe that maybe in dig into that and find out why that has changed.

I don’t know if it’s the short termism of The Wall Street and that’s kind of causing people to do that I’m not really sure but I think those were great points and I think really dealing through that doesn’t need to pay a buy back because he’s been so amazing at allocating the capital he has is Warren Buffett.

Other than that yeah they kind of need to give us the money back buybacks are great and it’s fine and dandy in a short term but I would rather have a dividend over the next 20 30 years if I own Apple for all that time I’d rather have a dividend then for them to buy back once or even four or five times.

There’s a lot of talk about what is Apple going to do with money that they’re repatriating from overseas they have two hundred fifty two billion dollars sitting in bank accounts outside of the United States and because of the tax code change they are able to bring it back to the United States and there’s been a lot of discussion about what they’re going to do with that money.

Part of it they announced that they’re going to do a hundred billion for a new share repurchase program and I know there are also been some brief discussions about a special dividend but Tim Cook kind of put a kibosh on that is. He’s not a fan of that but that’s a lot of money what are they going to do with that and one why wouldn’t they give it back to us and a dividend raised their dividend I know they’re going to raises their one 16 percent this year which is great. but why not raises some more I mean there’s just so many other opportunities and dividends or I’m sorry share buybacks are not bad and they are helpful but I do believe that maybe in the short term that’s more beneficial in that realm my thought is to have a dividend over the long time where I’m investing so that’s my thought.

Andrew: I’m going to end this episode with a quote from one of your favorite people Jamie Dimon the JPMorgan CEO, he was a that same CNN article I was referring to earlier he was quoted as saying critics of buybacks are people who are quote basically ignorant. So I thought that was I think I has a lot truth to it and yeah though we both agree that we’d rather have a dividend they’re not they’re not bad for the economy or for shareholders.

Dave: in no way shape or form are they. I agree.

All right well without any further ado I think that’s going to wrap it up for us tonight I hope you enjoyed our discussion on share buybacks and you learned a thing or two you didn’t know before.

So without any further ado you guys go out there and invest with a margin of safety emphasis on the safety have a great week and we’ll talk to you guys next week.

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