Author Topic: What are the danger signs for cannibal strategies  (Read 5594 times)


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Re: What are the danger signs for cannibal strategies
« Reply #20 on: April 20, 2018, 11:27:05 PM »
cyclical industries getting closer to the peak than the bottom. The airlines are a topical example, even though according to WEB: "this time is different".


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Re: What are the danger signs for cannibal strategies
« Reply #21 on: April 21, 2018, 06:38:36 PM »

When looking at a specific investment and evaluating capital allocation, I tend to look at the way the firm does buybacks (when, how, price paid). Market permitting, cannibal-like or Singleton-like persistence is welcome.

Short version summary:

-buybacks are running very high.
-buybacks are pro-cyclical.
-timing of buybacks, in the aggregate, is not that significant except in downturns.
-not all buyers are winners.
-price is what you pay and value is what you get.
-the authors suggest to measure (and report?) a specific measure of return on buybacks.

Longer version (optional):

I thought this was a useful report even if there are some limitations (methodology, choice of 5-year periods, returns not compared to index returns, some conclusions about their aggregate “effectiveness” measure, 2017 as the end-year).

They show (figure 1) that firms that do significant buybacks, in the aggregate, have positive results in terms of returns in the last few trailing 5-yr periods. Not that surprising, given that the markets in general have done quite well. I searched for comparable trailing 5-yr returns for the S&P 500 (total return, annualized, %, dividends re-invested, not audited):

2003-7: 12,7   2004-8: (3,3)   2005-9: (0,8)   2006-10: 1,6   2007-11: (0,6)   2008-12: 2,9   2009-13: 18,7   2010-14: 15,3   2011-5: 12,3   2012-6: 14,1   2013-7: 14,9

Eye-balling the numbers, it looks that firms doing large buybacks had returns comparable (+/-) to firms not doing significant buybacks.

Where it gets interesting is in the individual results. Using 14,9% as the market cut-off for the average for the last five years, some firms did huge buybacks with share prices persistently going up and the ROI measures on the buybacks are mostly high, with variations due to “effectiveness” (timing issues). An argument could be made that recent returns have been more favorable than usual, historically speaking. We’ll have to see. Some of the buybacks resulted in low and even negative ROI numbers. Some could say that it is easy to look retrospectively and be critical. Fair enough but, even putting the issue of leverage aside, there are many names there that should have refrained from buybacks (more on that later). Appendix III contains a lot of interesting info. The list likely contains some of your favorite investments.

What’s the point?

1-institutional pressures versus capital allocation decision

For many reasons (operating factors, wages, low interest rates, low tax rates), corporations have been very profitable lately. Also, for reasons that should be discussed elsewhere, in the last few years, firms have returned to shareholders (dividends and buybacks) a significant amount of free cash flow and more while investing relatively little towards expansion capital expenditures. I seem to remember that even Mr. Buffett and Mr. Munger have said recently (in the last year or so?) that it may be eventually difficult to justify having a cash pile reaching 150 billion at the holding company. When he was CFO at Google, Patrick Pichette used to describe the “degrees of freedom” associated with high cash levels and how he had a problem (an enjoyable problem) finding ideas large enough (super high IRR projects with relatively low NPVs simply did not reach the agenda) to redeploy this immense amount of cash coming in weekly. Before he left, in 2015, the cash pile was growing in correlation to institutional pressures but he used to say that the “share price does matter”. With cash coming in, super low interest rates and relatively low opportunities to re-invest in operations, for the typical firm, the pressure must be incredibly high to buy back shares (whatever the price?).

2-how to evaluate the trigger (hurdle) to make a buyback and why Mr. Buffett has used the 1,2 rule

In the context of a capital allocation decision, cap ex projects and business acquisitions are associated with uncertainty. But the uncertainty related to what will happen to the stock price going forward is much higher (price may go up or down). Just think of stock market variations versus GDP variations. That’s because stock prices have two components (fundamentals and sentiment) and one of the components can be emotional. With the option pricing models, the expected volatility of the share price will tend to correlate with the price of the option. Using that notion, IMO this may explain why the decision to buy back share should be based on a discount to intrinsic value. Most would agree that the 1,2 rule used by Mr. Buffett corresponds to a discount to intrinsic value, especially if you agree that book value, as stated, has been understating more and more the intrinsic value. I submit that the optionality associated with keeping cash unless the share price trades at a discount may be a reason why Mr. Buffet has chosen, and maintained so far, the 1,2 rule. This ties in to the question of being fully invested and to the fact that one should not time the market if the return hurdle is met. IMO, many companies forget that rule now and buy back their shares at a premium to intrinsic value. Those companies should instead use the excess cash to pay dividends or even invest in index-funds in order to maintain flexibility. In practice, for my investments, if a firm that I’ve invested in starts to buy back shares at a premium to intrinsic value, I will simply lower my estimation of intrinsic value. That may trigger a sell order and it seems that, in the aggregate and over complete cycles, selling shareholders will tend to do better during buybacks.

3-the ROI measure on buybacks used as a periodic yardstick

Mr. Buffet talks about the one-dollar premise (retained earnings test) whereby retained cash flows should be eventually be rewarded (long term and over cycles) by the market (ie reflected by higher stock price) if the capital allocation decisions resulted in profitable operations. The same way, from now on, I will periodically evaluate more precisely how the ROI on buybacks for a specific company compares to overall market returns.