In our healthcare consulting work one of the huge challenges we are working on is the ability of a pharmaceutical to produce adequate results in their research & development efforts. The challenge is constantly trying to figure out which project had the highest opportunity of product commercialization. In the last several years there has been an enormous shift in thinking about allocating capital in research. Rather than attempting to calculate which project to fund, focus has shifted to when investments shouldn’t be made. It turns out timing is more important than selection in many ways. A report by BCG (“Does Size Matter in R&D Productivity?” Nature Reviews Drug Discovery 12, 901–902 (2013)) summed it up best:
“The difference is not, therefore, about stringency – but about when you chose to apply the stringency as capital is expended”.
It turns out the problem wasn't what project to fund or defund, but rather when projects should be funded or defunded.
We bring this up because it turns out business managers have similar difficulties when it comes to stock buybacks. The issue is rarely whether buybacks make sense as a choice, but when buybacks are made. We were reading a recent article by Morningstar[1] discussing stock buybacks as half of the total yield question (the other half being dividends) and were surprised by the level of capital allocated towards stock buybacks.
Management’s Core Task: Allocating Capital
One of the truly critical requirements of a CEO is to decide upon allocation of capital. Perhaps no other task can have such an impact on shareholder return over the years. Certainly it is one of the key measures we use when analyzing a prospective investment’s management team.
Management is faced with three potential options when deciding how to allocate profits after all operating expenses have been paid. They can declare a dividend, return cash through share repurchases, or retain the cash to grow the business. We’ve discussed how a critical factor in our investment criteria is return on capital. We believe how management returns capital is equally vital in measuring management performance. We look for management that sees stock buybacks the same way we see as investing. Warren Buffet – as usual – said it best:
“Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated”.
For Buffett and Munger share repurchases (when you have the money and when the stock is cheap) are driven by both qualitative measures and timing. We think the latter is a key area of potential improvement for US management teams.
Stock Buybacks: Returning Capital Through the Back Door
Since 1992 there has been an explosion in management’s use of stock buybacks as a core capital allocation choice. In that year roughly 38% of S&P companies repurchased their shares at roughly 0.8% of market cap annually. By 2013 85% of S&P companies were buying back 3.2% of their market cap annually. Figure 1 below shows graphically the explosion in these transactions.
If one were to plot the timing of these purchases it would show managements’ decisions show purchases happening at exactly the wrong time. Figure 2 seen below shows share buybacks track market indexes pretty closely. The higher the market goes the greater the amount of buybacks. As a value investor this is the antithesis of what we look for in our investment processes – and we feel the same way about management who follow in this pattern.
Why This Matters
We like to invest in businesses where management uses their business savvy to achieve both high returns on capital and return of capital. We believe there are a couple of key learnings that can be taken away from the research.
By Low, Sell High: It Isn’t Just for Personal Investors
As simple as it may seem, it is extraordinarily difficult to live by the credo of buy low sell high. Whether its personal investors pouring money into tech stocks in 2000 or management stopping the repurchase of shares at market lows in 2009, all allocators of capital (and that's what we do as investors – allocate capital) must have a process in place which assure both criteria and timing make the best use of that capital.
Aligning Incentives Makes for Smart Return of Capital
Management is rarely incentivized to maximize return on capital. Far too frequently capital is used for propping up the share price or driving EPS growth through a reduced share count. If we are to see a wiser use of corporate funds we will need to see a collective action to move the goal line for managers. We recognize that there are tremendous capital allocators out there and we are painting with a very broad brush, but the bulk of data show this to be an ongoing issue.
Allocating Capital: It’s Our Job Too
It’s fine for many of us to poke holes in managements that exhibit poor allocation skills, but we need to understand as fiduciary stewards we have an equally – if not higher – responsibility. The decision to allocate capital through our investment decisions - buy/sell orders, dividend reinvestments, etc. – demands a great deal of circumspection and thought. As money managers we are no different than corporate managers. Poor allocation of capital skills make us poor investors.
Conclusions
The decision to buy back corporate stock gives us great insight into the allocation skills of corporate management. None of us would expect to succeed if we followed a buy high, stop-buying-at-lows policy. We shouldn’t expect successful corporate mangers to succeed either. These actions give us a measure of what capital allocation skills sits in the CEO’s office. Additionally understanding the “when” is as vital as the “what” when it comes to capital allocation. When you invest along with extraordinary allocators of capital (those who get the “what” AND “when”) it makes your life as an investment manager so much easier. And that’s something all of us would be happy to take to the bank.
As always we look forward to you thoughts and comments.
[1] “Dividends: Only Half of the Yield Story”, Timothy Strauss, February 19th, 2015
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