On September 10th, Senators Ron Wyden and Sherrod Brown introduced the “Stock Buyback Accountability Act” that would tax share repurchases by corporations. We think the logic behind this act is flawed and the disdain of stock buybacks is misplaced. We believe stock repurchases are a valuable tool in capital allocation decisions.
The Importance of Sound Capital Allocation
One of the pillars of ESG investing, and in our view the most important, is the role of governance by management and directors, specifically in capital allocation decisions. Early in a company’s life cycle, management teams are tasked with raising capital efficiently, through debt and equity offerings. Successful management teams navigate this process by raising enough capital to start and stabilize the business, at the lowest weighted average cost of capital (WACC).
In our view, as companies mature, investors should demand to see free cash flow, which is a sign of a healthy company with a strong business model. If a company cannot produce free cash flow, the entity will eventually fail.
Uses of Excess Cash
Once a company crosses the boundary from needing capital to fund its business model, to generating excess free cash flow, the management team and the directors face the following choices.
1) Continue to invest in the business with growth capital spent on new research (R&D), incremental hiring (labor) or properties (PPE) with the goal to generate returns on this capital over and above its WACC. Investing in any of these areas where expected returns are under the WACC, will typically weaken the enterprise.
2) Seek merger and acquisition activities that can provide superior capital returns. As acquisitions are a riskier form of capital allocation, companies must make sure they undertake appropriate due diligence activities, have strong strategic rationale for business combinations and restrain from overpaying for assets.
One of the key pillars of Rewey Asset Management’s investment philosophy is to identify companies that are not only generating excess free cash flow, but that also have the ability to reinvest this cash at higher returns than its cost, i.e. examples #1 and #2 above. Companies that consistently have this ability are true compounders, that can grow economic value and share prices over the long term.
If there are not enough opportunities to invest free cash flow in the business, we believe management teams should then turn to optimizing the capital structure, including:
3) Paying down debt
4) Paying dividends
5) Repurchasing stock
The Order of Capital Return Under Good Corporate Governance
Companies that do not have opportunities to invest all of their excess cash flow at superior returns, must make good governance decisions to improve their capital structure. Given our preference for strong balance sheets, our first preference is for companies to use their excess cash to reduce debt. We believe that companies with strong free cash flows and low debt are able to prosper over the long-term, and to survive unexpected shocks, such as the Covid crisis.
Once a company has paid down its debt to a strategically appropriate level, we believe a company should engage in paying dividends and repurchasing stock, i.e. returning cash to shareholders.
Dividends are an important part of capital return, and are valued as a sign of capital discipline and expected future capital structure stability. But, to maintain the promise of a consistent dividend over time, dividend levels are not designed to return 100% of the current excess cash a company produces. When a company has excess cash, over and above dividend levels, it can be appropriate for a company to repurchase shares in its own stock
When Not To Repurchase
Share repurchases must be undertaken only when they represent a strong governance decision on capital allocation, in our opinion. We frown on companies that buy at any cost, even inflated valuation levels. We urge companies to consider the cyclical nature of their business, and to hold excess capital in cash on the balance sheet if there is uncertainty on how long the period of excess free cash flow will last.
When To Repurchase Aggressively
When a company has the excess cash, and valuations are attractive, we urge companies to Carpe Diem, and aggressively repurchase shares.
Aggressive share repurchases, at attractive valuation levels, are not only a strong vote of confidence in the business by management and directors, but also accrue long-term benefits to the capital structure of companies. Equity is typically the most expensive form of capital in a capital stack, as it represents an ownership interest in the company. Attractively valued share repurchase programs can both reduce the dilution of ownership for remaining long-term holders, while also improving the long-term WACC of a company by reducing the amount of equity in the capital structure.
Don’t Villainize Stock Buybacks
Share repurchases can be an effective tool for managing free cash flow and adjusting capital structures. In our view, the broad disdain of repurchases and proposed legislation to restrict repurchases is misguided. Companies that follow good governance practices, including decisions on capital structure, will likely be able to compound superior value growth over time.