The Buyback Paradox

Earlier this week, I fielded a number of questions from a smart investor who sits on a number of non-profit investment committees.  His concerns revolved around the fact that most folks making  investment decisions are still stuck in the ‘old’ 60/40 mindset led by investment advisors that always think stocks are ‘cheap’.  While disappointed, I am not surprised that investor mentality is so slow to change.  To be honest, it represents an opportunity for those of us who can think more dynamically.  These are generational shifts in thinking we are talking about.  After the strongest bull market in history from 1982-2000, it will take more than a couple of grueling bear markets and a decade of zero returns from stocks to change their minds, although the shift is happening gradually as retail investors continue to sell down equity holdings amidst stomach-wrenching volatility.  My suggestion was that by the time said investors were willing to accept that Jeremy Siegel’s ‘Long Run’ is too long to wait, valuations would likely reflect their disgust,  and buy and hold will likely be prudent once again.  This long-term psychological cycle is what ultimately marks important bottoms in history as we saw in the early 40s and again in the early 80s after investors had completely given up on stocks.  We are not there yet, considering how quickly the ‘buy the dip’ mentality has roared back to life shortly after arguably the worst financial crisis in history.

Apparently, one reason advisors believe stocks are ‘cheap’ today is the abundance of cash on the sidelines.  China bulls make a similar argument when talking about Chinese FX Reserves.  The mistake in both cases, is to ignore the other side of the balance sheet.  Yes, companies do hold  piles of cash that could potentially be used to buy back shares.  But why do they have this cash?  I would submit that there are a few reasons, none of which have bullish implications. One, low interest rates encourage managements to issue debt – in some cases a lot of debt. Note that these new claims on the business are higher in the capital structure than equity, so stockholders should not be particularly excited about high cash balances which result from selling debt.  Two, the regulatory and political environment is not exactly pro-business in case you haven’t noticed today. Companies are holding cash because it is very difficult to make long term investments when the rules of the game and their tax consequences are impossible to predict even one week forward.  Cash on the sidelines is a sign of uncertainty, and frankly, I don’t see anything on the horizon that will change this.

Finally, many advisors are excited about the potential for these companies to buy back their shares with all that cash.  But like anything else, price is the ultimate determinant of forward returns.  Companies that buy back overvalued shares are destroying capital just as they would in making any other bad investment.  On the other hand, when shares are cheap, we would encourage management to buy shares aggressively as this may be the best use of that cash.  See Berkshire’s recent announcement for a sense of what a disciplined buy back should look like.  Unfortunately, Berkshire seems to be the exception.  The chart below from Barron’s illustrates very clearly that most companies do the exact opposite – they buy back their own stock in good times and pay top dollar to do so, but rarely buy the dips when shareholders get the biggest bang for the buck.

Andy – next time someone mentions that cash on the sidelines is a bullish indicator for big stock-buybacks, show them this chart.  I look forward to their response.

Source: Barron's