Insights

A system awash in liquidity and the consequent asset price inflation results in capital misallocation decisions. One such area is corporate buybacks. A decision to buyback shares is a capital allocation decision. Just as with any capital allocation action, it should be done when it represents a good use of the company’s capital. In our view, a share buyback should be done when it satisfies the following criteria.

1. 1. The business has excess cash available after accounting for growth and maintenance capital allocations,
   2. Utilizing such cash flows for buying back will not impede the business’s flexibility in dealing with poor economic, financial, or business outcomes, and
   3. The shares can be repurchased at prices that are below the appropriately assessed business value.

However, that is not how much of the corporate suite seems to act. Much of the corporate buybacks we are seeing in this cycle aren’t driven by the value and price relationship. Instead, corporate managers have primarily focused their attention on per-share earnings to justify such actions. In an environment of artificially low interest rates, such a metric frequently leads to inappropriate decisions. It is crucial to keep in mind that when a company buys back its shares at prices higher than what they are worth, it results in a transfer of wealth from the hands of those shareholders who choose to stay invested to the hands of the selling shareholders.

The table above shows the cumulative 10-years of free cash flows and buybacks through the end of 2019 for six airlines. As is seen, these six companies together spent nearly all of their cash flows on buybacks. We agree that the pandemic couldn’t be predicted. But that is the entire point of a rainy-day reserve. You don’t know when it will be needed. But when needed, you don’t want to be caught short. The lack of financial flexibility, which resulted from not having retained their cash flows, meant that these businesses were caught short of such reserves.