What Investors Don’t Get About Buybacks

Shareholders trust the management teams of companies to make sensible use of the profits generated. Investing those profits wisely can greatly increase future profitability and, hence, shareholder return. Overpaying on an expansion project, for example, will do the opposite. Recently there has been increased focus on companies using their cash stacks to buy their own shares¬†rather than looking for good ways to invest to grow. The question I am going to address is (and it’s an important one) is Does it matter at what price a company buys its own shares?

The intuitive answer, and one that many professional investors and commentators would give, is “of course, buying at a lower price is always better”. The reasoning is that companies that buy their stock before the price goes up get more bang for their buck than those that buy before it goes down. As a result, investors scold companies that buy at or near peak levels in their share prices (this article from Fortune is one of a very large number I found online).

But it actually does not matter. In fact, I can reverse the intuitive answer with two simple arguments:

(1) The shares the company buys get cancelled. The company is not investing in its own shares. Shareholders have no claim on the shares that are bought back and so do not gain or lose if this is done at a high or low price.

(2) When a company buys back its shares, it is buying them from shareholders. Shareholders always prefer to sell shares at a high price and therefore should thank any company that buys from them at such a lofty level.

Argument (1) is pretty solid but I think it’s worth digging into (2) in more detail. Shareholders as a group should prefer the “buy high” approach, but at the individual level those that sell to the company at the peak are better off (following a subsequent fall in price) than those who choose to hang on. That the latter group did not sell at the peak is not the fault of the company or in any way linked to a buyback or lack thereof.

Here’s another way to think about it: if companies had perfect foresight on their share price would they still buy back shares today if they knew the price would be lower in a week?

This is not just a theoretical exercise since companies do have inside information that can give them a sense of the short term trajectory of their share prices.

The answer, again, is that it does not matter. Neither the shareholders nor the company is better off if the buyback is delayed. The company can buy more with a fixed pot of cash if it waits, but the total value of equity following the buyback will be the same regardless of the timing.

However –¬†and here’s where the intuitive answer starts to look (somewhat) good again – the share price will actually be slightly higher in the case when the company delays the buyback (let me know if you want proof of this). Any shareholder who would not sell regardless of when the buyback takes place is better off if the company waits a week. But, shareholders on average will not gain from this “buy low” strategy and, if the company does not buy at today’s higher price, shareholders miss out on the option of cashing in at a better price.

The discussion should not focus on whether timing buybacks in a certain way creates shareholder value (it does not), but how the decisions of individual shareholders to sell or not seem better or worse as a result of the timing. The actions that a subset of the shareholder base might take should not determine the way in which companies divvy out the spoils, so shareholders would be better off redirecting their attention to monitoring the use of the cash that actually stays in the company.