Monday, January 14, 2013

Repurchases, Part 3: Joe responds

In two previous posts Repurchases: Part 1 Shareholders Beware and Repurchases Part 2: The Positive Side, Joe and I have debated the merits of repurchases.  Today's blog contains Part 3, Joe's response.  We'll conclude (maybe) our current discussion on repurchases on Wednesday.  We'll both respond to these points and try to summarize.



Perhaps, I was overly critical of share repurchases in my previous post. Ralph raised several good points to which I would like to offer some clarifying comments.

1) Shareholder distributions, dividends and repurchases, do not increase value since they do not affect firm cash flows. They are, however, correlated with value changes.

2) Not all repurchases are created the same. Their impact depends on their size, premium offered, execution method, and funding. Small, excess cash funded, low premium open market repurchases are associated with small effects.

3) Everything that can be done with a repurchase can be done with a combination special dividend and reverse split. My point is to understand what is driving management's choice of a repurchase over a dividend, and whether it serves the best interests of continuing shareholders. A possible motivation  may be that while most stock option plans adjust for repurchases, they do not adjust for dividends. Thus, stock options are worth more to executives when cash is returned through repurchases v dividends. Interestingly, Berkshire Hathaway, which recently announced a repurchase, does not grant large levels of options and restricted shares to its executives thereby avoiding this issue.

4) The danger of a value transfer from continuing to selling shareholders exists when management overpays relative to the stock's intrinsic value for the repurchase. Berkshire provides an excellent example of pricing discipline in its repurchase policy. They state repurchases will be approved only to return excess cash when its shares are trading for less than 120% of their net asset value,  i.e. intrinsic value.

Bottom line, trust, but verify. Repurchases are more complex than they first appear. The FT's 1/2/13  Lex Column put it best: "Companies should manage cash carefully so a payout is sustainable across the cycle. Failing that, special dividends work just fine, thanks. Cash that a company earns that cannot be invested for adequate returns belongs to shareholders. Keep it simple, and return it to them.".



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