There are two ways you can ultimately realize cash from an investment.
One is that the company issues a dividend. The second is you sell the stock (whether it is forced upon you or not – for the purposes of this post, I am assuming that your shares are not being forcibly bought out).
There is a whole bunch of academic literature on question of whether dividends or share buybacks are the best form of returning cash to shareholders. In theory, when removing the impact of taxes and transaction costs, there is an indifference between a dollar returned via dividends or through share buybacks. However, the cliche of “in theory, theory and practice are the same, but in practice they are different” applies.
Since I can remember, the debate whether dividends or share buybacks provide the superior return mechanism has resulted in very different philosophies between various management teams.
The core issue is that a dividend triggers a tax hit today (in addition to the top marginal rate being significantly more expensive for a dollar of dividends versus a dollar of capital gains) while a buyback is perpetual (to the extent that management doesn’t mess up and issue shares for cheaper later!) and cumulative. A buyback does, however, trigger a 2% share buyback tax in Canada which does offset this differential somewhat. A buyback also has the effect of elevating a company’s share price for a temporary period of time due to the demand on the stock during the period of the buyback – this will also elevate the cost to shareholders for management compensation as in many cases there are RSUs, options and other stock price-linked financial instruments that will accrue to management’s pockets.
Over the course of a couple decades, I’ve assembled my practical rules of caution concerning companies that engage in share buybacks:
1. If the company’s balance sheet is debt-laden, be very cautious when they execute share buybacks and considering paring, if not outright selling entirely the company.
and in conjunction – 2. If a company decides to incur additional debt in order to buy back shares, be cautious.
Rule 2 is due to a “non-debt laden” company deciding to take out debt in order to repurchase shares.
Needless to say, if the company’s balance sheet has other priorities, stock buybacks can be very dangerous to a company’s financial health.
Essentially management is making a decision that the cost of their debt is lower than what returns will accrue to the shareholders. From a metrics-perspective, this will increase the return on equity but does not increase any fundamental profitability of the company itself. As long as these calculations are correct and the company can continue to deliver sustained profitability at or greater than the cost of debt, coupled with the gross amount of debt not presenting any liquidity/solvency challenges when it comes time to roll over said debt, it will give the present shareholders a one-time boost.
Ag Growth (TSX: AFN) (late 2024/early 2025) is a poster child for this rule. They repurchased shares in the upper 40s and the stock is now sitting at $14 – with a looming refinancing on the horizon.
Dye and Durham (TSX: DND) is another great example – in fiscal (June 30) 2023, they repurchased $223 million in stock. The buyback was entirely funded by debt.
This category also covers the cases where companies are performing significant amounts of expansionary capital expenditures at the same time as executing a share buyback – capital that otherwise would go to expanding the profitability of the business is instead directed to share buybacks – why not just allocate it all to the capital project (or acquisition)?
3. If the company’s management performs a buyback when share prices are at all-time highs, be cautious and consider paring into the demand.
Many tech companies have gotten in trouble with this rule – valuation insensitive buybacks are destructive.
The year 2000 is littered with examples of this, but in more recent times, we have amusing examples of Silicon Valley Bank repurchasing shares in 2022 (and going bust in 2023), Enphase buying back stock in 2022-2023 at around $200/share, etc. Lululemon was repurchasing shares at $350-450/share in FY2023-2024, and the list goes on and on.
4. If the industry is cyclical and the company is buying back stock, be cautious.
Good examples here include Western Forest Product (TSX: WEF) which repurchased about $120 million in stock (at much higher prices) in 2021 and 2022 during the Covid lumber boom, and Alpha Metallurgical Coal (NYSE: AMR) which repurchased over $1 billion in stock in 2022-2023 during the coal boom. Note that both of these companies have relatively low amounts of debt on the balance sheet presently, so they were truly disposing available cash at the time.
Teck was going to be one of these stories until they stopped their buyback after the Anglo American buyout announcement!
All of the oil and gas majors in Canada right now are gushing cash flow and are repurchasing shares at all-time highs – looking at Cenovus Energy, for example – in the past 12 months they have given out $1.5 billion in dividends, and repurchased $3.2 billion in stock. That said, the majors have mostly de-levered themselves so the “what to do with the cash” problem is pleasant for them to deal with – CNQ have decided to go with a more dividend-heavy route, and companies like Tourlamine and Peyto reject buybacks entirely.
In my experience, when a company buys back its own shares, it is more of a reason for caution than celebration. There are two cases where buybacks are beneficial:
1. Management uses an appropriate valuation metric to decide whether to buy back shares.
If a management team can restrain themselves to only repurchasing below a certain valuation, it is likely a sign of well-allocated capital. Examples coming to mind include Mullen Group (TSX: MTL), whose last repurchase was at $14/share, or Magellan Aerospace, where they last repurchased shares at an average of $15/share. Both companies have share prices in excess of this, and management has stopped buying back shares. Andrew Peller (TSX: ADW.a) repurchased a small amount of its Class A shares in the 4’s before stopping.
2. The company perpetually generates positive cash flows.
A very special case is Corvel (Nasdaq: CRVL) which has been repurchasing shares for the past 3 decades. While they have sped up and slowed down their buybacks over the years in accordance to their stock price, the buyback has been wildly accretive to shareholders. NVR is another company that has derived its returns entirely through share buybacks.
However, just because such a buyback has been historically a good decision does not necessarily mean it will be in the future – and an investor needs to always be aware of that.
If you are holding shares in a company, at the very least you do not believe it is worth selling at the current price (taking into account capital gains taxes and/or reinvestment alternatives). If a company is on the upper threshold of your valuation metric and then decides to purchase shares off the open market, there is only one good way to defend against a share buyback that is commenced for wrong reasons – and that is to sell your shares while the price of the stock is temporarily elevated by management. Chances are, after the buyback is concluded, you would likely be able to purchase shares at a lower price some point in the future.
There is no “one rule for everything” with respect to this topic – every situation has to be individually analyzed – but the above are some considerations in mind – not an exhaustive list.
