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High Earnings Quality Companies Do More Buybacks

Posted by Vident Financial on 4/12/21 11:00 AM

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 tended 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) had 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 tended to be more likely to be able to afford to buy shares back. Companies that are struggling with cash flow issues had trouble finding the cash to disburse to their shareholders. Buybacks/concentration seem to be flowing out of growing pies, not financial austerity turnip-squeezings.

 draft 2frequency of buyback concentration by roic quintile

Source: FactSet, Vident, Bowyer Research

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.”

 draft 2frequency of buyback concentration by gross profit quintile

Source: FactSet, Vident, Bowyer Research

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 were 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 engaged in buybacks/concentration 24% of the time. Those companies were much less likely to bet on themselves and by definition had 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.

draft 2buyback frequency differential by earnings quality factor

Source: FactSet, Vident, Bowyer Research

Performance quoted represents past performance, which is no guarantee of future results.

 

Topics: Stock Selection Research

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