Investment guru Peter Lynch once said, “Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldn’t it invest in itself, just as the shareholders do?”
When it comes to share buybacks there are several schools of thought. Some prefer the profit to be reinvested back into the business, some prefer it to be paid as dividends, and some prefer share buybacks.
Today let’s discuss one of them. Are share buybacks a great way to reward investors?
If the role of management is to allocate capital, I am sure the decision will be based on what the best outcome is to create value for shareholders in the long term.
Share buybacks normally increase earnings per share (EPS) as the company buys its own shares and cancels them which decreases the company’s equity and increases the company’s return on shareholders equity.
So, it’s important to look at EPS, not just earnings overall.
Share buybacks are exciting! The company buys back its own shares from the market and cancels them resulting in an increase in profit per share as highlighted in the graphic above.
As Warren Buffett said, “If you do it at the right price, there’s nothing better than buying in your own shares.”
Share buybacks do add value but they only make sense if the stock is trading at a discount not a ridiculous price.
The other option is if there is not an alternative way to deploy the capital and buying back shares is the best way to reward shareholders.
Fund manager Mohnish Pabrai gave a lecture to students recently and it was interesting.
He stated if a business’s earnings grow 15% yearly and 84% of the shares are taken out it will be a 100 bagger in 20 years with no price earnings (PE) multiple changes which means an investment of £10,000 will become a million pounds in 20 years. Very impressive isn’t it?
However, if earnings grow 10% a year, 80% of shares are taken out and the PE multiple expands by 50%, it will be a 50 bagger, will increase by fifty fold, in 20 years time.
Source Mohnish Pabrai
This is called Uber Cannibal investing which shows you can get a great investment return not just by growth but by also investing in a company that’s cash-rich, undervalued and aggressively focuses on share buybacks.
The interesting part of share buybacks is after the company buys back 80% of the shares outstanding.
However, some companies also do the opposite by issuing shares to raise money and continue to dilute the value of the shares. In the long run, this can be costly for investors because the question is, if the company is self-sustaining, why does it need to dilute the value of the shares rather than producing the cash internally to do buybacks?
Success in investing comes by investing in companies that are run by exceptional management and the company has to have some sort of monopolistic stability over the next 10-20 years. This can be achieved by investing in an economy or sector that will prosper for many years to come and also by creating conditions that support your patience. As the great Charlie Munger once said, “The big money is not in buying or selling but in the waiting.” That’s what ultimately matters in the long run.
Awet Ghirmay, Head of Investment Research
If you want to learn more about this topic, please find the link here.
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The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
