Financial Engineering and Share Repurchases

In investing, financial engineering refers to using mathematical principles to present a higher level of earnings. In the current low-growth environment, share repurchase is one of the most common financial engineering strategies employed by firms.

The stock market continues to trade within shouting distance of its all-time highs. In such an environment, it is harder to justify spending shareholder cash to repurchase what could potentially be described as overpriced stock. In the past, Warren Buffett has commented that using company cash to repurchase shares that seem overvalued represents a betrayal of shareholders and is a sign of bad management. This view is not necessarily shared by all investment managers, but given the importance of valuation in BWFA’s analytical process, it is one that is always considered when we evaluate stocks for potential inclusion in client portfolios (See also dividend versus stock repurchase).

Historically, companies have not done a good job of buying back stock. Instead, they tend to buy high and sell low, which is the exact opposite of what they should be doing. For example, according to the Wall Street Journal, as the market hit a then-record high in 2007’s third quarter, corporations repurchased $214.3 billion of their shares, which was more than twice the amount they repurchased at the depth of the bear market that followed – they repurchased a combined $97.3 billion in the fourth quarter of 2008 and the first quarter of 2009 combined.

When companies repurchase shares, they reduce the number of shares outstanding. This is an important factor when calculating earnings per share (EPS), because net income (the earnings in EPS) is divided by shares outstanding to determine EPS. The fewer shares there are outstanding, the larger EPS becomes.

Over the past few years, many companies have been buying back stock each quarter. One can argue that this is being done simply to make their quarterly earnings look better than they actually are, based upon year-over-year business growth.

At BWFA, we believe effective capital allocation is one of management’s most important responsibilities. We recognize that there can be differences of opinion about the value of a particular company’s shares. However, we tend to frown upon companies that appear to be repurchasing shares merely because they hold too much cash. As a result, we always try to understand the logic management is using when it decides to allocate capital to repurchase shares.