Active vs. Passive Buybacks

Share buybacks frequently destroy value — An active approach to repurchases is best — Executing this strategy is a challenge.

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ACTIVE VS. PASSIVE BUYBACKS

Not all share buybacks are created equal. In fact, many repurchase programs fail to create value for companies and shareholders.

With share repurchases, the seemingly simple act of returning capital to shareholders becomes a complex capital allocation exercise. Ignoring the complexity associated with buybacks destroys shareholder value.

Leveraging Insider Knowledge

Businesses repurchasing shares have a unique advantage, as by definition, they can purchase shares while possessing inside information. No investor is as informed about a business’s future as management and board members.

Share repurchases should leverage this advantage. Repurchases should be executed sporadically, only when shares trade below intrinsic value. Optimal share repurchase programs occur infrequently and generally in times of market stress.

Despite the obvious benefit of this strategy, few businesses leverage this advantage. It is an open question why so many management teams do not have the ability to estimate their own business’s intrinsic value. 

Ignoring Return

Many businesses have ongoing share repurchase programs that buy stock regardless of price. By pursuing this strategy, management sends an unclear signal to the market.

Either management cannot evaluate its own share price against the business’s intrinsic value, or it is unwilling to try. This “throw up your hands” approach results in a dollar-cost averaging strategy.

The only other alternative is that management is so convinced about the future opportunities of the business that no price is too high to repurchase shares. It is rare, though, that the market fails to properly price shares for years at a time.

Management teams buying back shares regardless of price, and believing they are creating value, must think their businesses are truly exceptional. This is more likely a sign of blind overconfidence than the business actually being an undiscovered compounder.

Dollar-Cost Averaging

To a certain extent, returning capital to shareholders, without imperiling a business’s capital structure, is never a bad decision. Shareholders do have the ability to convert ongoing buybacks into synthetic dividends by slowly selling their shares back to the business.¹ 

But investors must understand that the dollar-cost averaging approach is unlikely to result in outstanding investment returns. Due to the power-law nature of returns, 55% of businesses underperform one-month Treasury bill returns.² Dollar-cost averaging buybacks are an implicit bet by management that their business is an outlier.

Notably, investors using a dollar-cost averaging strategy typically invest in diversified indices, seeking to capture market beta. With this strategy, investors can generally earn the long-term market return of 7-9%. Businesses investing in their own shares lack the diversification required to capture the market beta.

Active Buyback Management

While taking a valuation-conscious approach to buybacks is clearly the correct strategy, particularly when factoring in inside information, executing this strategy is a challenge for management teams.

Berkshire Hathaway provides an excellent case study on how to implement a valuation-conscious buyback. In 2020 and 2021, Berkshire deployed over $50 billion to repurchase approximately 5% of its shares. At the time, Berkshire traded for less than $280 per share vs. nearly $500 today.

Today, Berkshire is sitting on its largest cash pile in history. Buffett clearly believes the shares are trading near fair value and that they have been for the past four years, as cumulative buybacks since 2022 have only amounted to ~$19 billion.

Berkshire has the management, board, and shareholder base to execute these disciplined buybacks, and the patience to wait, years or decades, for the market to provide a buying opportunity. Few businesses have this luxury.

Shareholders have different investment horizons and liquidity needs. Maintaining the discipline required to actively manage a buyback program is sure to generate mixed feedback from investors.

Back To The Beginning

Businesses taking a more active approach to buybacks must ensure they have the fortitude to follow through on their strategy over the long term. For a business without a disciplined board and a strong shareholder base, actively managing a buyback may not be an option.

As usual, Berkshire Hathaway provides the leading example of capital allocation and shareholder value creation. Following this example, public market investors should work more closely with the businesses they invest in, offer long-term support, and enable their investments to enhance the value of their buyback programs.

Unfortunately, in today’s passive investment world, this shift in shareholder behavior is unlikely. Which brings us back to the beginning.

The dollar-cost averaging strategy benefits from both its consistency and simplicity. Given the fickle nature of public market investors, this simplicity may overwhelm the benefits of actively managed buybacks.

At the end of the day, shareholders can appreciate buyback programs simply for the return of capital, which is better than nothing.

Notes:

1. After a share repurchase, a shareholder will own a larger percentage of the business. To convert a repurchase into a dividend, a shareholder can sell shares to keep their ownership percentage the same. This conversion of a repurchase into a dividend ignores any taxes and transaction costs.

2. “Do Stocks Outperform Treasury Bills?”