Dividends, I get. When a company wants to give money back to its shareholders (on a regular basis) it initiates a dividend. When the business grows, it increases the dividend. But if the business is growing so fast that management might need the cash quickly—for investing in new equipment, or for an acquisition—then the dividend might be pretty small, or they might not even have one.
But stock buybacks are different. With a stock buyback the company buys its own shares, in the market or via tender. It’s a way for the company to use its cash to reward shareholders—buy only shareholders that are selling. They come about when the company has more cash than it needs, but only temporarily.
But companies also use share repurchase to take advantage of undervaluation. When managers think their firm is trading below its intrinsic value, they can buy shares in the open market. Indeed, researchers examined when companies announce buybacks combined with employee purchases. The results were striking: from 1991 to 2010, value stocks that announced buybacks when managers were also buying the shares for their own portfolios significantly outperformed the market in all kinds of conditions.
This makes sense. If executives are selling their shares, or exercising stock options and then selling, then share repurchases just transfer company cash to management. But if managers are buying and the company is buying, then they likely think the stock is cheap. Presumably, managers would be in a good position to know this.
Share buybacks are a legitimate way for a firm to give back cash. They can also signal that the company is undervalued. When managers and the firm are both investing in themselves, it’s a good sign.
Douglas R. Tengdin, CFA
Chief Investment Officer
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