Jerry Bowyer | On February 11, 2021

A Pile of Cash
(Photo by 401(K) 2012) (CC BY) (Resized/Cropped)

In our ongoing series about stock selection which has first focused on how companies pay their shareholders, we’re going to take a slightly deeper dive into buybacks.

Reminder: We are referring to situations in which a company reduces the number of shares in circulation by repurchasing them in some way, thus leaving the remaining shareholders with more concentrated ownership in the underlying assets of the company.

For a theoretical example, if a company buys back half the circulating shares, that means that the remaining shareholders own twice as much of the company. Think of a small business with ten equal partners. The business buys the shares of five of them. Before that, each partner owned 1/10th of the company. Now, the remaining partners own 1/5th of the company. In financial parlance, this is called ‘concentration’. When things go in the opposite direction — more shareholders, more ‘partners’ (in the general sense, not necessarily the legal definition) — then a smaller share is owned by each.

We’ve seen earlier in this series that buybacks/concentration have come under some attack, despite the fact that there are good arguments for them. We’ve seen that sometimes buybacks/concentration are beneficial to investors and sometimes they are not.

Now, let’s see which situations tend to coincide with buybacks/concentration in the same calendar year. Which kinds of companies tend to do them? When do companies tend to do them?

First let’s look at the metric Return On Invested Capital, or ROIC. Here’s how Investopedia defines it:

“Return on invested capital (ROIC) is a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments. The return on invested capital ratio gives a sense of how well a company is using its money to generate returns.”

You can see below that companies which have high rates of ROIC tend to be much more likely to do buybacks/concentration. The top quintile (meaning the top 1/5th of instances in which companies in our universe have a reported ROIC) have an average of 52% of instances of ownership concentration.

The bottom quintile of ROIC, meaning the worst 1/5th, only show an average of 22% of ownership concentration instances.

This makes sense. Companies with high returns tend to be more likely to be able to afford to buy shares back. Companies that are struggling with cash flow issues will have trouble finding the cash to disburse to their shareholders. Buybacks/concentration seem to be flowing out of growing pies, not financial austerity turnip-squeezings.

Source: FactSet, Vident, Bowyer Research, 12/31/90 – 12/31/19

Let’s look at a similar metric: Gross Profits as a Percentage of Assets. Here’s how Investopedia defines Gross Profit:

“Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services.”

Source: FactSet, Vident, Bowyer Research, 12/31/90 – 12/31/19

We see a similar picture. The higher the profit return on assets — i.e., the better the company is at using its assets to create this specific broad definition of profit — the more likely they are to reward their owners by offering to buy back their shares. When a company buys back its shares, it is betting on itself. This happens much more often when companies are good at turning assets into profit.

The top quintile, the best 1/5th of instances of this factor, engage in buybacks or otherwise concentrate their stock 47% of the time. The bottom quintile, in which companies are particularly bad at turning a profit and are instead predominately producing losses, only engage in buybacks/concentration 24% of the time. Those companies are much less likely to bet on themselves and by definition have less profit to do so even if they wanted to.

Here’s a nice overview of some metrics that have to do with earnings quality, such as the two we saw above, and whether they tend to coincide with buybacks/concentration in the same calendar year.

Source: FactSet, Vident, Bowyer Research, 12/31/90 – 12/31/19

Originally published on Townhall Finance.

Jerry Bowyer

Jerry Bowyer is a Forbes contributor, contributing editor of AffluentInvestor.com, and Senior Fellow in Business Economics at The Center for Cultural Leadership.

Jerry has compiled an impressive record as a leading thinker in finance and economics. He worked as an auditor and a tax consultant with Arthur Anderson, as Vice President of the Beechwood Company which is the family office associated with Federated Investors, and has consulted in various privatization efforts for Allegheny County, Pennsylvania. He founded the influential economic think tank, the Allegheny Institute, and has lectured extensively at universities, businesses and civic groups.

Jerry has been a member of three investment committees, among which is Benchmark Financial, Pittsburgh’s largest financial services firm. Jerry had been a regular commentator on Fox Business News and Fox News. He was formerly a CNBC Contributor, has guest-hosted “The Kudlow Report”, and has written for CNBC.com, National Review Online, and The Wall Street Journal, as well as many other publications. He is the author of The Bush Boom and more recently The Free Market Capitalist’s Survival Guide, published by HarperCollins. Jerry is the President of Bowyer Research.

Jerry consulted extensively with the Bush White House on matters pertaining to the recent economic crisis. He has been quoted in the New York Times, The Wall Street Journal, Forbes Magazine, The International Herald Tribune and various local newspapers. He has been a contributing editor of National Review Online, The New York Sun and Townhall Magazine. Jerry has hosted daily radio and TV programs and was one of the founding members of WQED’s On-Q Friday Roundtable. He has guest-hosted the Bill Bennett radio program as well as radio programs in Chicago, Dallas and Los Angeles.

Jerry is the former host of WorldView, a nationally syndicated Sunday-morning political talk show created on the model of Meet The Press. On WorldView, Jerry interviewed distinguished guests including the Vice President, Treasury Secretary, HUD Secretary, former Secretary of Sate Condoleezza Rice, former Presidential Advisor Carl Rove, former Attorney General Edwin Meese and publisher Steve Forbes.

Jerry has taught social ethics at Ottawa Theological Hall, public policy at Saint Vincent’s College, and guest lectured at Carnegie Mellon’s graduate Heinz School of Public Policy. In 1997 Jerry gave the commencement address at his alma mater, Robert Morris University. He was the youngest speaker in the history of the school, and the school received more requests for transcripts of Jerry’s speech than at any other time in its 120-year history.

Jerry lives in Pennsylvania with his wife, Susan, and the youngest three of their seven children.