Actively Speaking Podcast
Steve Bleiberg, portfolio manager and thought leader at Epoch Investment Partners, Inc. (TD Epoch) takes on current topics and issues facing today's investor.
Actively Speaking Podcast
Share Buybacks on the Rise: Understanding Their Use
With share buybacks on the rise, Shareholder Yield Portfolio Manager John Tobin, PhD joins to discuss how shareholders benefit when a company buys back its stock. He also explores why management teams should not try to time their buybacks. Finally, John and Steve explore the impact of the U.S. tax on buybacks that went into effect at the beginning of 2023.
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For institutional investors only. TD Global Investment Solutions represents TD Asset Management Inc. ("TDAM") and Epoch Investment Partners, Inc. ("TD Epoch"). TDAM and TD Epoch are affiliates and wholly owned subsidiaries of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries. The information contained herein is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information is distributed with the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein as well as any risks associated with such proposal or services. Nothing in this presentation constitutes legal, tax, or accounting advice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Certain information provided herein is based on third-party sources, and although believed to be accurate, has not been independently verified. Except as otherwise specified herein, TD Epoch is the source of all information contained in this document. TD Epoch assumes no liability for errors and omissions in the information contained herein. TD Epoch believes the information contained herein is accurate as of the date produce...
Hello and welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Hello, welcome back to another episode of Actively Speaking. My guest today is John Tobin, who's a member of our shareholder yield team. John , welcome.
Speaker 2:Thanks, Steve. Good to be here. We're
Speaker 1:Gonna talk about subject that's been in the news again lately, and I , something I know that's near and dear to your heart, which is share buybacks. And the , the prompt for this specifically was an article in the Wall Street Journal , uh, just a few weeks ago with the headline Share Buybacks Continue at <inaudible> pace while investors sit on sidelines. And , uh, one of the lines , uh, I like to quote from the article says, share repurchases have long faced criticism in Washington and elsewhere from those who , uh, from those who argue companies should invest in their growth instead of boosting shareholders. Uh, this seems like no matter how many times we've tried to knock down this idea, people just are listening apparently. What's your response to that, that line in the article?
Speaker 2:Well, you know, you're absolutely right, Steve. It's criticism that we've been hearing literally for years. It , it kind of seems like it won't go away. So we have to keep addressing it and happy to keep addressing it 'cause we do have , uh, a good response to it. I think what I'd probably say to begin is we have a , a way of thinking about capital allocation and it, the model we use, we call it our, our our five uses of cash model. And it really puts , uh, the whole capital al allocation decision making process into a framework that makes it really straightforward. So, five uses of cash, what are they? Company that generates cash flow can invest organically to grow through capital expenditures. They can invest to grow inorganically by mergers and acquisitions. They can buy other companies and they can pay a dividend, they can buy back stock and they can pay down debt. And that's really it . So if you think of capital allocation along those lines, the, the, if you will, the important part of the analysis is , uh, trying to understand or trying to see if the company management team understands how to do the capital allocation, right? Which is to say they look for opportunities to invest to generate a return above their cost of capital. And when they can do that with their cashflow, that's exactly what they should be doing. And when they run out of those wonderful ideas, they should be returning the capital to the owners of the business. And so our view all along has been we want companies to invest. We need companies to invest. That's the only way that they can grow. But we want them to invest. If they earn a return above their cost of capital, that's value creative . If they use cash to invest and they're not earning a return above their cost of capital, it's value destructive. So our view is , uh, the excess cashflow that can't be deployed profitably should be returned through dividends. Share buybacks or debt reduction share buybacks is just one of the ways that a company can return capital to the owners of the business. It has the advantage as it has an advantage of flexibility. So a company pays a dividend, they announce a dividend when a company reduces a dividend or cuts a dividend, that really has a powerful negative signaling effect. But on the other hand, if a company dials up or dials back the share buyback activity, depending upon their cashflow generation, depending upon their opportunity set in terms of investment ideas and opportunities, that's something that they can do easily without generating that negative , um, kind of connotation. So that's how we look at companies allocating capital. That's how we, it's, it's in that context that we think about share buybacks, and we just think it's one way, one legitimate and effective way that a company could return excess capital to the owners of the business. And it's as simple as that. Really.
Speaker 1:Yes. There , there's, there's implicit argument in, in that line I quoted from the article about quote , companies should invest in their growth is they are implicitly assuming that any dollar reinvested in the business is a good idea , that it will , it will always generate a good return on, on investment. And sometimes that's simply not the case.
Speaker 2:Absolutely. Yeah.
Speaker 1:Um, and then the other part of that sentence was invest in their growth instead of boosting shareholders. So talk about why, why is it that people have this perception that, that the sole purpose of buybacks is somehow to quote boost shareholders? What , what do they mean by that, do you think?
Speaker 2:You know, it, I I don't really know <laugh> , to be honest. Um, it , you know, we, we have a capitalist system and we have a businesses that are owned by shareholders. Uh, there's a view today, which I think is the correct view that we should think perhaps more broadly about stakeholders. So it's not just the shareholders that we should think about, but that doesn't mean that we shouldn't think about the owners of the business at all. And I , it's sort of part and parcel of the they should be investing to grow. And as you just said, the implicit assumption is that any dollar that isn't kept in the firm and reinvested is somehow not going in the right direction. You know , the whole efficient capital markets hypothesis, I suppose in a way is capital should flow to the, to the place that it gets the highest return. And for a business management team to say, we don't have any really good ideas, but we're not gonna give the money back either that that's not good for society ,
Speaker 1:Good for society . Yes. Yes. I mean, you know, years ago I was in the 1990s , uh, I was in charge of a , managing a portfolio of Japanese equities. And , uh, it was a constant issue in Japan that companies business would throw off out of cashflow. And, and, you know, you listed before the five uses of cashflow. The truth is there's a sixth, which is just sit on it, don't do anything with it. And that, that was by far the favorite use of cash in Japan. And in those days, and I remember once being at a meeting with a , a , you know, well-known Japanese company and with a bunch of other investors, and somebody asked , uh, what's the management representative who was there? You have this massive cash balance on your balance sheet. And of course, interest rates at the time in Japan were already pretty close to zero because of, they had had the whole collapse, the real estate market around 19 89, 19 90, and , and rates had gone very low. So it wasn't earning anything , uh, you know, why don't you give that money back to the shareholders? And the response from the, the fellow at the company was essentially, well, we might need it someday . If you don't do anything with it , if you don't invest it and you don't return it to shareholders, you're really kind of locking it up and it's not generating any sort of return for the company. And it , we always like to talk about on, on the capital reinvestment strategy, how the cost of capital can be thought of as an opportunity cost, because shareholders always have something else they can do with the money. You know, and , and management set companies need to sort of recognize they're not the only game in town, and that if they give the money back to the shareholders, the shareholders can go invest it elsewhere. Maybe some other companies do have better uses for that money , uh, and if they buy stock in that company, you know, maybe that's gonna be a better investment for them. But, but coming back to this idea of quote boosting shareholders , um, as, as if that was <laugh> , that's a bad thing. You wrote a piece, I believe , uh, you know, now probably four or five years ago , uh, which I think had the title of something like, you know, dividends by another name or something like that talk . Exactly . And , and you know, nobody seems to think paying dividends is a bad thing, even though that could be quote boosting shareholders. Can you just sort of remind us of the , you know, what you said in that piece? I mean, perhaps you've covered it to some extent already in our discussion, but, you know, when you, when you call share, when you call buybacks , uh, dividends by another name, you know, what are you getting at there?
Speaker 2:Well, it , again, it , it's , um, it comes outta that five uses of cash model that there are three directions you can go with the cash that are broadly speaking, shareholder returns. We refer to that as shareholder yield, and that's dividends share, buyback and debt reduction. And they are all , uh, in a certain sense, equivalent ways of returning cash flow to the owners of the business. The dividend is of course, straightforward company pays a dividend , uh, the shareholders receive the dividend, and it's a very tangible reward from the profits of the business to the owners of the business. And it, it's true that the share buyback is a little bit less straightforward. I don't see the share buyback show up in my brokerage account when the company does share buybacks. So how should you think about it? Well, the way to think about it, I think is it's accretive for the , uh, continuing owners of the business and to use a maybe , um, sort of a mundane , uh, kind of example, if you were in a business partnership and there were five partners and you and four of your best friends started a , I don't know, a restaurant business or something, and at some point in time, one of them decided, gee, this has been great, but I'm ready to move on. So I'd like to cash out. If the four other owners got together and used the excess cash flow of the business to buy out the fifth partner, then those, each of those four remaining partners would now own 25% of the enterprise instead of 20% of the enterprise. And the, the critical piece of that analysis is that the enterprise value is the same. So to assume it's like your restaurant business, if you've got five restaurants, you still have five re you didn't have to sell a restaurant to generate the cash to buy out the partner, you bought 'em out with excess free cash flow . So the enterprise value, the cash generating ability of that capacity of that business going forward in time isn't diminished just on a bigger stake in that business. So share buybacks are accretive for the remaining owners of the business. So even though I might in my brokerage account not do anything, I haven't changed my share position , uh, I know that the company's gone through a share buyback over the course of the year and nothing showed up in my brokerage account. And, you know, for large corporate businesses , uh, my stake might move by a fraction of a decimal place, but I'm still a bigger owner. Right . Of the remaining enterprise . And by the way , uh, debt reduction is another one that sometimes people look at you and sort of say, explain that to me. How is that accretive? Well , uh, again, a a very simple mundane sort of example. We all wanna pay off our mortgages. And because we know as we pay down the mortgage, it increases our residual ownership interest in our homes, there's a, a bank that no longer has as large a claim against the asset. And it's exactly the same thing with a business. If I'm an equity owner in a business, my residual equity ownership goes up when the debt claim against that enterprise goes down. So for us, as we look at what can a company do with its cash, if they use some of their cash to pay down debt, that's accretive, that's shareholder yield. And that's good too.
Speaker 1:Yes . I , you know, there's a nuance there that I think a lot of people miss when they talk about this, particularly like this article. I'm citing this idea that the value of the business is, is the present value of the feature cash flows it's gonna generate. And it's kind of going back to the Miller Modigliani theory for those who are familiar with, with, you know, finance theory, how you apportion out those. I mean, in the absence of taxes, how you apportion out the, the ownership claims on on those cash flows doesn't change. The cash flows themselves. So there's often this confusion. I find that people think that the reason that managements do this is 'cause they think somehow they're, they're fooling the market that because, for example, if you, if you buy in the number of shares and the number of shares goes down and the earnings haven't changed, well the earnings per share have gone up. And so there's this view that many people have that all they're trying to do by buying back shares is trick the market into thinking the company is worth more. 'cause now it has more earnings per share. But of course, you know, the markets are pretty efficient at realizing that yes, there's more earnings per share, fewer shares, same, same enterprise values . You were saying the the criticism that's behind that often is based on the idea that management actually is gonna , is gonna benefit from higher earnings per share simply in their comp plans. But , you know, give you a chance to bat that down.
Speaker 2:Well, you know, and that's exactly right. And it , it's true that , um, if you grow earnings and you reduce the share count , you grow earnings per share faster than you grow earnings. And the idea that there's something nefarious going on here is, is silly. Really, the more you think about it, it's, you know, it's not a bug, it's a feature. You know , <laugh> , if you , if you buy back stock earnings per share growth , uh, is faster. And that's , uh, we're not trying to do something or management teams are not trying to do something , uh, shady. That's , uh, that's actually a desirable outcome. But you raise a good point. One of the criticisms is that this is very, a very easy way for a management team to boost their bonuses if they get paid according to earnings per share growth with the same level of earnings. So in other words, maybe they're not doing a very good job of growing the business and growing the earnings of the enterprise, but if they keep buying back stock, the earnings per share keeps going up and their bonuses keep going up. Fair point . But I think that's something that's been , uh, well understood for a long time and management compensation schemes today, you know, they take that into consideration. And that's one of the things that we look at when we meet with management teams. And I know you guys do too, on the , uh, the capital reinvestment team. You want to know what's the management compensation program here? Are you getting compensated for earnings per share growth? Or are you getting compensated for generating a return on capital above your cost of capital? Are you getting paid to grow cash flow and free cash flow ? So there , there are many, many metrics that can and are used in management compensation schemes today, and it's way more sophisticated than, you know , you get, you grow EPS by 10%, your bonus goes up by 10%. Right . It really isn't like that.
Speaker 1:Right. Um, here , here's another one that we can talk about the , um, criticism, which has to do with, and I know this is kind of a, you know, a pet peeve of yours. Timing, the idea of management should be timing buybacks because why are they buying, you know, if the stock, suppose the stocks at an all time high, which again could just be indicative of the fact that the value of the business has continued to grow and , you know, which they do, or successful businesses will constantly be hitting new all time highs if they're doing it right. Um , but people will say, well, why are you buying back stock when the , when the stock is at an all time high, why wait till it's cheap? Um, you know, how do you think about that?
Speaker 2:It's true. It's a , a frequent criticism that , uh, management teams are notoriously bad at timing their share buybacks. Um, and again, our view is, it's , it's really, really hard to tell when a stock is approaching a peak and turning lower or when it's at a trough and about to turn higher. If we could time those peaks and troughs , uh, we'd all be wealthy and we'd all be retired. So it just as it's difficult for an investor looking at a company to, to pinpoint those turns in the stock, the management team doesn't have any particular insight either. So our view is, look, if you've got excess free cash flow , and it gets back to your earlier point, if you've got excess cash flow , you don't have a good use for it now give it back now, don't sit on it and wait for a better opportunity to come along. Don't sit on it and wait for a better time to buy back the stock cheaper. And , and , and as you also just pointed out a minute ago, the trajectory of a stock for a successful business is upward. So you could continually say to you, why are you buying the stock back now at $35 a share? It was $25 a share last year. You should have been buying it back last year. Well, if I'm doing a good job, it'll be $45 a share next year. Right. So
Speaker 1:Right . There's also an assumption that, you know, the stock prices just meander sideways and you should, you know , buy at the troughs and, and uh , and sell at the peaks, you know, as if it's never going up over the long run.
Speaker 2:Yeah. So it's , um, I suppose you , you could come up. It's easy enough, I suppose, to come up with an example, hypothetical example of a stock that has gone up , uh, spectacularly over the past year. And you might agree with management that, well, I don't know if I'd be buying back the stock now. Stock just went up a hundred percent. And there are stocks that have done that recently. But as a general rule of thumb, as a general guiding principle, the idea is don't try to time it. If you have excess cash flow , you don't have a better use for it, just give it back.
Speaker 1:Right. Well, I , there is sort of an irony in that, in that argument to me, which is that it , it makes it clear that people who make that criticism don't really understand this , uh, what we're we're saying about really it's all about proper capital allocation because it's almost like they would ra rather that the company hold onto the cash even, you know, if they don't think they have a good investment use for it in the business, but oh, the quote , the stock price is high, so better for them to just sit on the cash and, and have it essentially earn nothing or, you know, these days at least you can earn a little bit on the cash as opposed to giving to the shareholders who again, could do other things with the money. There's, they , they really don't get that concept of the opportunity cost of capital and that for the , for the company to choose consciously to just earn nothing on the money rather than paying it out so that the shareholders can go do something else with it is, is kind of surprising. Um ,
Speaker 2:And it just one more sort of ironic element to this, and I've had this conversation with , uh, with CFOs, if the stock is up and you say to them, what about your share buyback program? And if the CFO were to say, well, I don't think we'd be buying the stock back here. 'cause the stocks really run a lot, and if you say, so you're telling me you think your stock is overvalued here? Oh, no, no, no. And I wouldn't say it <laugh> . I mean, if if you believe that the stock is fairly valued, then you shouldn't have any , uh, reason not to buy back the stock. But when you sort of turn it on in that way and , uh, it gets them , you know, backpedaling pretty quickly. Yes . Now I , I wouldn't wanna say that my stock is overvalued now .
Speaker 1:Yes. Yeah. Uh , one last , uh, question. So I guess on January 1st of this year, a tax on buybacks when into effect , uh, 1% tax , uh, are you, is it having any effects ? Do do managements talk about this at all when they talk about buybacks?
Speaker 2:Well, we've , uh, it's part of the conversation because it's , uh, it's something that we've asked company management teams , um, and others. It's relatively new. And so the question is, is this gonna matter? And so far the general answer is not really Companies that have excess cash continue to utilize the cash for share buybacks. They don't seem to be deterred by , uh, tax on the share repurchases. It's a , creates a little bit of friction in the system, but it, it really hasn't changed behavior. I suppose the concern of the worry might be that those who are , uh, legislating those changes might look at this and say, well, obviously we haven't raised the tax high enough 'cause it hasn't changed behavior. Uh , I'm sure there is a point at which that tax would be high enough to alter behavior. But even then the management team, I would hope would still look at capital allocation if you will, appropriately and say this particular avenue of capital distribution is now less efficient because of the tax that's being assessed going down that path. Well, we can raise the dividend, we can declare a special dividend. That's something that US companies don't do very often. But that was often historically a technique and a , and a method that was used by European companies, for example. They, they had for a long time a bit of a bias against your buyback. So if they had extra cash in, you know, in excess of what they would normally be paying out in terms of their dividend, they would declare a special dividend. So if managements continue to adhere to the basic principle, invest when you can earn a return above the cost of capital, otherwise return it, I would hope that even if the folks in Washington decide to ratchet up the tax on share buybacks to the point that it does cost some pain, that management teams continue to adhere to good capital allocation practices and find another way to give the money back to the
Speaker 1:Shareholders. Right . And am I thinking about this correctly, that on a , on a net basis, it's still sort of cheaper for in , in total for the company to pay the 1% tax on the buyback and get and do that rather than pay it out as a dividend given that the shareholders would have to pay a lot more than a 1% tax on that money if they received it as income. So, you know, it might, there might be sort of a , a weird perverse incentive for the company to, well, you know, we don't wanna pay the tax, we'll make the shareholders pay the tax by giving them a dividend. But overall it's actually still more cost efficient for the, for the company and the shareholders together for the company to do it as a buyback rather than as a dividend. It's,
Speaker 2:It's , I think that's right. I think that's the right way to look at it. Yep . Yeah.
Speaker 1:Okay. Well, John , thanks very much for , uh, joining me,
Speaker 2:Steve. It's a pleasure. I always enjoy having our conversations.
Speaker 1:Uh , that'll wrap it up , uh, for this episode and we'll be back again with another episode sometime soon. Remember to subscribe to actively speaking on Apple Podcast, Spotify or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com.
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