How to Buy Back Shares

One of the most critical tasks at a company is the deployment of capital. The Intelligent CEO can reinvest in the existing business, repurchase stock, issue dividends, pay down debt, or acquire other companies. I wrote about reinvesting in the business, and today, I want to dig more into buying back shares. 

A company might use its earnings to buy back shares to increase shareholders' ownership. It's easier to buy back shares in a company you know rather than buying out another company. For this reason, I believe it's better to buy back shares rather than opting for an expensive and often doubtful M&A program. Regarding share buybacks, the key is always to purchase shares below the per-share intrinsic value of the business. Intelligent CEOs buy one dollar for eighty cents to benefit from a margin of safety and good returns. Therefore, repurchasing shares below the company's intrinsic value improves the wealth of shareholders. 

Warren Buffett gives an example with Coca-Cola: "When Coca-Cola uses retained earnings to repurchase its shares, the company increases our percentage ownership in what I regard to be the most valuable franchise in the world. Instead of repurchasing stock, Coca-Cola could pay those funds to us in dividends, which we could then use to purchase more Coke shares. That would be a less efficient scenario: Because of taxes we would pay on dividend income, we would not be able to increase our proportionate ownership to the degree that Coke can, acting for us." Share buyback programs are better than receiving dividends and then reinvesting because of the tax implications.

The Intelligent CEO Henri Singleton bought back 90% of Teledyne's shares. His strategy generated an astonishing 42% compound annual return for shareholders, way higher than the S&P 500. Sometimes, the best investment opportunity is your stock. Of course, it requires the company to have a strong cash position and an Intelligent CEO being extraordinarily patient and highly aggressive when the time comes. 

The caveat is that often buyback programs are executed at prices far higher than the per-share intrinsic value. Quoting Warren Buffett: "Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price." Managers destroy capital to lure speculators into buying the expensive company's stock. This pump and dump scheme is alas too common. Another tricky situation is when the company buys out shares issued as low-priced stock options. Quoting Buffett: "This "buy high, sell low" strategy is one many unfortunate investors have employed—but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully."

In my opinion, after reinvesting earnings in the company, buying back shares below the business's intrinsic value is the second-best option when it comes to deploying capital. Intelligent CEOs can create a lot of value this way. All they need is a reasonable calculation of the intrinsic value, a margin of safety, patience, and boldness at the right time.