Where I got greedy-when-fearful wrong

I erred in suggesting buybacks a year back. Business-owner context ≠ investor context.

A year ago, carried away by freefalling stock prices, I wrote an essay on buybacks. I suggested that, for a limited set of strong businesses who are well capitalized, it’s worth seriously evaluating whether a buyback makes sense. While this sounded reasonable, I was dead wrong. My suggestion was ill-timed and ill-advised.

Context matters. In a standard-issue downturn or bear market, my reasoning would’ve been fine. March 2020’s external context was far from standard. Country shut. Businesses shuttered. Zero revenues for months. Widespread psychological scarring. Complete opacity on timing or strength of recovery. I also erred on internal context. For an investor, buying undervalued stock is everything. For a business-owner amidst a generational crisis, it’s nothing. Promoters have more important obligations towards vulnerable dependents: employees, suppliers, sub-contractors, distributors, dealers, families of the above. Product development or capacity addition cannot be interrupted. Business should be prepared to quickly react to an absurdly wide range of scenarios. Purpose of cash cushion is to allow undiluted focus on such real problems over financial ones.

I got some small things right. Buyback is a high-risk investment decision, masquerading as cash being returned to owners. Buybacks are opportunistic and sporadic. They shouldn’t affect prospects or risk of core business. Capital structure is about sleep-well-at-night. However, I missed the obvious inference that followed out of these. A crisis was no time for opportunistic distractions outside the core, especially one that reduced balance sheet cushion. For a business-owner, fearful when fearful was the right answer.  And that’s exactly what all good promoters did. No one considered buybacks. Most did the opposite, drawing down additional liquidity. A few even diluted equity. Focus was solely on health, safety, people and business issues. Risk-first approach worked well, allowing better businesses to capitalize on a faster-than-anticipated recovery and gain over peers. Promoters’ judgment was sound, unlike mine.

(I am attaching below my original essay, published on March 16, 2020. While it’s still ill-timed for valuation reasons, it’s hopefully not as ill-advised in normal times.)

*****

It’s buyback time! For some.

At a time when buybacks make sense for an increasing number of companies, it’s worth delving into what they really are and why they’re not equivalent to dividends at all. Buybacks are opportunistic, price-dependent, unpredictable and sporadic. Dividends are systematic, price-independent, (generally) predictable and routine. While whatever I’ve said so far is trivial, businesses and shareholders have often mixed up the two. Let’s look at each, in detail.

Dividends are a return of surplus cash back to those it belongs to. No more, no less. A business and its cash belong to its owners. After investing to sustainably grow the business and keeping a rainy-day cushion for (inevitable) tough times, a business cannot deploy cash in a manner that is either justified or lucrative. Then, dividends are simply the right thing to do with excess cash. Doing so also prevents wrong things. Idle cash is a devil’s workshop, increasing odds of destructive deeds such as M&A, diversification or ego projects. Hence, the discipline of an appropriately-sized periodic dividend that grows in line with the business is highly preferred. While dividends are meant to be generally stable, they don’t have to be perfectly so. Reducing them due to tough times or lumpy capital expenditure is reasonable. Dividends are meant to be the default and predominant mode of returning cash back to owners. Messy stock markets have no bearing on dividends. They’re determined entirely by the real world.

Buyback is a high-risk investment decision, masquerading as cash being returned to owners. Imagine a CFO at a board meeting with a proposal to invest surplus treasury funds into stocks. To make it worse, CFO wants to invest a meaningful amount into a single stock. Most boards would quickly get on the phone with an executive recruiter on a CFO mandate. This is exactly what a buyback is. Even when the stock in question is closest to home, this is a risky decision not to be taken lightly especially since the quantum involved is typically much larger than with dividends. This route is to be followed when odds are very favourable. Specifically, valuation matters. As Big B said, in investing, what is smart at one price is stupid at another. Buybacks should be an occasional and minor mode of returning cash back to owners. Since messy stock markets are involved, timing is unpredictable.

A buyback is a sensible, if not attractive, way to allocate capital if two conditions are satisfied in the following sequence:

(a)   Company has a strong balance sheet that can afford the buyback without affecting prospects or risk of the core business.

(b)   Company is clearly undervalued by the market, relative to what the business is fundamentally worth.

If, and only if, these conditions are met, a buyback can be beneficial to both the company and its shareholders. Shareholders who differ on prospects or time-horizon can exit, entirely of their own volition. Continuing shareholders get a substantial benefit of increased ownership in a wonderful business at favourable terms. As an illustration, GEICO’s buybacks took Berkshire Hathaway’s ownership from 33% to 50% over a few decades. Investing an affordable sum in one well-understood business at an attractive valuation makes this is a prudent option for allocating surplus capital.

On the first condition listed above, I hasten to add that I am not a believer in an ‘optimal’ capital structure or in compromising balance sheet in any way. In my view, an optimal balance sheet is one that lets promoters and senior management sleep well at night. While I may have an opinion on how much cash is adequate, across a fairly broad range of reasonableness, I avoid second-guessing promoters on this. As there’s no right answer, it’s best to go with the judgment of those with longest time horizon and maximum skin in the game.

Moving onto the second condition, I feel more confident opining on whether this is met, especially at the extremes. For a wonderful business, the second condition is rarely met, offering a limited window in which a buyback makes sense. Since stock-prices are unpredictable, buybacks are inherently opportunistic and require timely action during such periods including present times. While the buyback process in India is cumbersome, there are rare occasions when the hassle is well worth it. I wish this process would get way simpler, with some loose constraints to prevent misuse by those with weak balance sheets.  

How about tax considerations? Don’t let the tail wag the dog. Ideally, tax planning should be a minor input into strategic decisions. Empirically, this isn’t so. It has the unfortunate character of being perfectly quantifiable, making people overweight its importance. This has distorted factory locations, supply chain risk and corporate structures. Companies literally end up tilting at windmills on this account. Tax is particularly distorting in matters pertaining to dividend and buyback. While tax differentials are precisely known, value destruction (of buying back overvalued stock) is fuzzy yet way larger. The very framing of the problem as dividend vs buyback is wrong. The right framing is dividend no matter what, with the only question being how much. The buyback problem enters the picture only on rare occasions when above conditions are met. There are also conflicts of interest as tax planning of individuals gets mixed up with capital allocation of companies.

While a substantial decline in share prices has made buybacks more attractive, I am not making a broad-based recommendation. Weak businesses or those severely impacted by the current pain could fail the first condition. The case for strengthening cash cushion may be a lot stronger than for a buyback, irrespective of how attractive valuations are. For a limited set of strong businesses who are well capitalized, it’s worth seriously evaluating whether a buyback makes sense. In many cases, current valuations may still be too expensive to justify a buyback. In some, a timely buyback could make eminent sense. Keep the dividend flowing, though!

[PS. How to gauge whether the condition on undervaluation is met? Promoters and management are experts at building businesses, not at valuing them. ‘How to think about business valuation’ merits a separate essay if not a book. Here’s an oversimplified view, intended to provide rough guard-rails around this problem. Assuming a decent business earning healthy return on capital, start with a PE multiple that uses historic, actually-delivered earnings as its input. If recent year earnings are depressed or below-trend, feel free to use prior year or multi-year average earnings. Now, here are my fuddy-duddy limits on whether to do a buyback. If PE multiple is well above 25, don’t. Well below 20, do. In between, discuss. Wait, aren’t these way below where fashionable businesses have been valued in recent times? Absolutely. Prudent investment decisions require us to be guided by history, not fashion.]

(Originally published at https://www.linkedin.com/pulse/its-buyback-time-some-anand-sridharan/)