Share Buybacks vs Insider Buying

Good article in The New York Times: "Stock Buybacks Demystified".

Some snippets:


Corporate insiders have impeccable timing when buying stock for their own accounts. When the ratio of insider buying to selling is higher than normal at many companies at the same time, it tends to be near a market low.

That was the case in late 2008 and early 2009, toward the end of the last bear market. The ratio was at historically high levels for months, just before stocks tripled, according to Vickers Weekly Insider, a service that tracks such trading.

But when bosses authorize buybacks — buying stock on behalf of their companies, not themselves — they show nothing like the same foresight. The $617 billion that companies in the Standard & Poor’s 500-stock index spent on buybacks in the 12 months through January 2008 was the highest amount in the nine years for which the research firm FactSet has compiled such data.

That was just in time for the worst market decline since the 1930s. The following year, a more auspicious time to accumulate stocks, buybacks totaled $353 billion.

“Insiders, when buying for themselves, are not looking at the present; they’re looking at the future. Buybacks are done for the present; cash flow is high, so they use it for buybacks. That drives them in good times and bad.”

Buybacks tend to be done late in an uptrend because that’s when there are fewer attractive alternatives for spending money and the greatest need to lift earnings. But that’s also when stock valuations are high. If companies borrow to accomplish their buybacks, as many do, it leaves them even worse off when the cycle turns down because they have more debt on their books, he added.


I have never been much of a fan of share buyback programs. I have seen enough cases in which these programs were abused, for instance :

• A share price was "defended" at some artificial price level. When the money for the share buyback program ran out the share price crashed, not unexpectedly. The company should have let the share price go down, enabling it to buy more shares at a cheaper price, for the advantage of all remaining shareholders.
• An aggressive share buyback program exactly at the moment that insiders are selling the share. There is the perception that the share price is artificially supported, enabling insiders to receive a higher price than they otherwise would have.

Share buybacks have been invented in the US, having had a double taxation on dividends.

Asian countries don't have this double taxation, so they can freely distribute excess cash in the form of dividends. There is here actually not much need for share buybacks (with this being a possible exception).

I prefer dividends over share buybacks:

• Dividends are much more transparent, an overview of the dividends paid out in (say) the last ten years is quite insightful in evaluating a company.
• Share buybacks are distracting, both for the management which has to execute it (dealing on a daily basis with price and volume), and for the shareholders who have to evaluate it in combination with the dividends.

Netflix: the danger of share buybacks

Good warning regarding share buybacks. Netflix was way too optimistic, kept on buying back its shares even when the price was around $250 per share. It now has to replenish its cash by issuing new shares at a price of $70. A real nightmare scenarion for minority investors.

I wrote about dividends versus share buybacks before:

http://cgmalaysia.blogspot.com/search/label/dividends

Netflix: When It Rains, It Pours

Talk about bad things leading up to other bad things.  Netflix stocks plunged yet another 8% to $68.50 on Nov. 23, two days after the company announced concurrent common equity and convertible notes financings totaling $400 million.

The company said it raised $200 million through the sale of about 2.86 million shares of common stock at a public offering price of $70 per share, for gross proceeds of $200 million, and raised $200 million through the private placement of convertible notes to funds affiliated with TCV, a private equity firm.

Netflix had $159.2 million in cash and cash equivalents, and $206.57 million in short-term investment at the end of September.  But the sum of these two could only cover 40% of its current liability of $968 million as of Q3 2011.  Moreover, the company's Current Ratio (current asset divided by current liability) stood at 1.2, barely above the minimum threshold of 1.  So it is evident that this latest endeavor is to repair its balance sheet and cash flow.

Business 101--Buy Low, Sell High.  When it comes to share buyback and issuance, companies like Exxon Mobile typically do them within its stock price historical range.  Netflix was a $50-range stock before it exploded in 2010.  However, as the chart from the Bespoke Group illustrates, Netflix bought back at triple-digit per share price and spent $302 million since 2010, while selling low with this latest stock issuance.

This suggests a sign of desperation--the last thing a company wants to do when its stock is already at only 22% of the price four months ago.  Furthermore, it also exposes Netflix management's failure to properly manage its risks and balance sheet, as this current "cashflow crunch" could have been averted had the management been more conservative during the good times.  

 

Chart Source: Bespoke Group, 23 Nov. 2011

As recent as 4 months ago, Netflix was an almost $300 stock, but mostly due to a series of  strategy implementation blunders by the management, its stock has been on a serious downward spiral losing about 78% of its value from $298.73 on July 13 this year.  This has definitely upset many investors, particularly for those that bought in at 3-digit price when the stock seemed unstoppable.

Now, to add insult to injury, this latest stock-prices-depressing move most likely has crushed whatever sliver of support Netflix shareholders still had of the company.  Already having trouble containing a widespread subscriber revolt as it is, Netflix has now managed to also infuriate and alienate probably all shareholders.

Generally, when a company has to do something drastic, such as a $400-million cashflow repair, that might spook an already nervous market, CEOs and corporate executives (this is one reason they get paid the big bucks) need to be able to spin (or sell) it into a positive convincingly to investors and the big boys on Wall Street.  After all, the hit on share price would not have been as significant if all major shareholders have your back.  But judging from the recent Netflix stock momentum, it looks like not only had the big players sold off the shares, a good number of them are most likely shorting the stock.

On that note, we think Netflix shares could have more downside risks unless some extraordinary ground-breaking event emerges to shift the market dynamics.

Although most current shareholders probably have taken a bath on the stock, there are a few who have benefited from the Netflix drama.  For example, WSJ reported that Chief Executive Reed Hastings has been a steady seller exercising options as low as $1.50 for as much as $262 a share.  Since Mr. Hastings seems to have been able to at least manage his own portfolio risks quite nicely, there could still be hope for Netflix?

http://www.businessinsider.com/netflix-when-it-rains-it-pours-2011-11

Dividends or Share Buybacks?

When companies have excess cash, they should distribute this to the shareholders. For this, they can:

• either pay the money in dividends 
• or buy back their own company shares and subsequently cancel the shares, increasing the earnings and assets of the remaining shares

My clear preference is dividends, I have yet to meet an investor who complained about having received too high dividends.There is only one catch, some investors don't like it when the dividend is cut, so if companies want to pay dividends and know that part of that is due to a one-off event (for instance an asset sale that brought in a huge profit), they could declare part of it as "special" dividend, indicating that it might not be repeated in the future. A clear dividend policy towards the investors would also help in this matter. Another advantage is that dividends are very easy to track, even years in the future one can look back and check how much has been paid in the past. 

Issues surrounding share buybacks:

• Share buybacks only make sense if the share is undervalued, but value is in the eye of the beholder. This issue doesn't play a role for dividends.
• Buybacks must be monitored, the company should make sure that they don't buy more shares than say 20% of the volume done that day. Thus, it can easily distract the management of the company, they should better be focused on their own business instead of monitoring buybacks.
• I have seen companies "defending" their share by massively buying stock at a certain price, after they exhausted their money, the share tanked and the company even lost money on paper.
• I have also seen examples where the company bought large amounts of shares exactly when the CEO sold his private shares. 

All in all, I would strongly prefer dividends over share buybacks, it is more easy, more transparent and can not be abused. Only if the share buyback is executed correctly, the positive effects might be similar to the effects of dividends.

The only company that might use buybacks actively is a closed-end fund: when the share is trading below its Net Asset Value, it could buy some shares and keep them in Treasury. When the share is trading above its Net Asset Value, it could slowly sell some of its Treasury shares.That way it could ensure that the gap between the share price and the Net Asset Value per share is not too large.