Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / The Hidden Signal in Stock Buybacks
Transcript
- Lucas: So I was digging through the selloff in Microsoft this week — down almost five percent over five days, and it's not alone. Amazon and Meta are off similar amounts. But here's what caught my eye: Microsoft is still buying back stock at the same clip it was before the rout. And that got me thinking about buybacks more broadly, because they're not all the same. Some create real value, and some are just financial engineering. Luna: Yeah, I feel like buybacks get a bad rap these days. Everyone talks about them like they're inherently manipulative, but that's not always fair. What's the actual difference? Lucas: Right, so the classic argument for buybacks is that they return cash to shareholders in a tax-efficient way, and they can signal that management thinks the stock is undervalued. But the nuance is in whether the buyback is actually accretive to per-share value. If you're buying back shares at a price below your assessment of intrinsic value, you're creating value for the shareholders who stay. If you're buying back at a premium, you're destroying it. Luna: So it's all about price discipline. But how do investors actually tell which one is happening? The company doesn't just tell you, 'Hey, we're overpaying today.' Lucas: Well, they kind of do, if you know where to look. Take Microsoft as an example. They've been buying back stock aggressively for years, and their stock has compounded nicely. But in this recent selloff, they're still buying back at around the same dollar amount. If the price drops five percent, that means they're buying back more shares for the same money, which is actually more accretive. But the flip side is if they'd been buying back at the peak, they'd be doing themselves and shareholders a disservice. Luna: So the timing matters a lot. But isn't there also a difference between authorizing a buyback and actually executing it? I feel like a lot of companies announce huge programs and then never follow through. Lucas: Exactly. Authorizations are like a blank check from the board. They can sit there for years. The real signal is in the actual repurchases — what the company reports in its cash flow statement. You want to see consistent, meaningful buybacks that align with the company's free cash flow. If a company is borrowing money to buy back stock at a high valuation, that's a red flag. But if it's using excess cash and the stock is trading below your estimate of intrinsic value, that's a green light. Luna: Got it. So what's a concrete example of a company doing it right? I'm thinking of NVIDIA, which is up over four percent this week while the rest of tech is getting hammered. Are they buying back stock? Lucas: They are, and they've been doing it consistently. NVIDIA's buybacks are actually a big reason why their earnings per share growth has outpaced their revenue growth in recent years. They generate enormous free cash flow, and they're returning a good chunk of it to shareholders. The key is that their buybacks are funded by cash flow, not debt. And they're buying back at what, historically, has been a reasonable valuation, even though the stock has run up so much. Luna: So the market is rewarding that discipline. But what about a company like, say, some of the legacy tech names that are buying back just to offset stock-based compensation? Isn't that more of a wash? Lucas: That's a really good point, and it's more common than you'd think. A lot of companies issue shares to employees as compensation, and then they buy back the same number of shares to keep the share count flat. That's not really returning capital to shareholders; it's just preventing dilution. The net effect on per-share value is zero, but it still shows up as a huge buyback number on the cash flow statement. You have to look at the net change in shares outstanding to see if the buyback is actually shrinking the float. Luna: So it's like a mirage. The headline says 'we bought back X billion,' but really they just offset their compensation expense. How do you filter that out? Lucas: You can look at the diluted share count over time. If it's flat or shrinking, the buyback is doing something. If it's growing despite the buyback, then they're not keeping up with dilution. Also, look at the ratio of buybacks to stock-based compensation. If that ratio is around one, they're just treading water. If it's significantly above one, they're actually returning capital. Luna: That's a nice framework. So what should a stock picker do with this? I mean, we just saw NVIDIA's stock pop, and Microsoft's drop. Are there any buyback signals in that price action? Lucas: Well, here's the thing. When a stock drops suddenly, and the company has an active buyback program, they often step in to buy more shares because they see it as an opportunity. That can put a floor under the stock. But it's not always a smart move — if the stock is falling for a fundamental reason, buying back shares is just catching a falling knife. So you have to ask: is this buyback a sign of confidence, or is it just management trying to prop up the stock price? Luna: So you're saying we should be skeptical of buybacks during a downturn, right? Lucas: I'm saying we should examine the motivation. If a company is buying back stock while also cutting R&D or laying off engineers, that's a bad sign. They're sacrificing long-term growth for a short-term boost to earnings per share. But if the buyback is funded by excess cash and the company is still investing in the business, then it can be a great signal. Look at Berkshire Hathaway — they're not big on buybacks, but when they do them, it's very deliberate and at a discount to intrinsic value. Luna: Yeah, and speaking of Berkshire, they had a rough week — down three percent. But that's probably not a buyback issue. Lucas: No, that's more about the broader market rotation. But it does tie into how we think about buybacks in a portfolio context. You know, this conversation reminds me of something a listener once said about how our show helps them think through decisions differently. It's part of why we do what we do. Luna: Oh, absolutely. And it's also why we keep this show free and ad-free. If our conversations have helped you think about an investment decision differently, and you feel like supporting us, you can buy me a coffee at buy me a coffee dot com slash fexingo. Lucas: That's right. Every little bit helps keep us going. And honestly, if today was worth a coffee to you, that's the link. No pressure, just a nice way to say thanks. Now, back to buybacks — I want to talk about one more thing: the impact on valuation metrics. Lucas: When a company buys back stock, it can make its price to earnings ratio look cheaper, because earnings per share goes up. But that's an accounting effect, not an economic one. The cash spent on buybacks is gone, so the company's intrinsic value per share only increases if the buyback was done at a price below intrinsic value. So you have to adjust for that when you're comparing P/E ratios across companies. Luna: So you're saying a lower P/E might just be a buyback illusion. That's a useful warning for stock pickers. Lucas: Exactly. That's why I always look at the price to earnings ratio in the context of the company's capital allocation history. If a company has been a good allocator, buying back stock at reasonable prices, then a lower P/E is more likely to be real. But if they've been profligate, buying back at the top, then you should be more skeptical. Luna: That makes sense. Are there any sectors or specific companies right now where you see a particularly interesting buyback dynamic? Lucas: I'd point to the energy sector. Chevron is up almost three percent this week, and they've been a consistent buyer of their own stock. The oil majors have been using their windfall profits to buy back stock, and that's been supporting their share prices. But you have to ask: at what point does that become value-destructive? If oil prices drop, those buybacks could look pretty dumb in hindsight. Luna: So it's all about cycle awareness. What about the financials? JPMorgan has been buying back stock for years, and they're up this week too. Lucas: JPMorgan is a good example of a company that does buybacks with discipline. They have a clear framework: they buy back enough to offset dilution, and then they return excess capital above that. They've been consistent, and they've been rewarded for it. But again, you need to look at the price they're paying. If JPMorgan is buying back at a price above book value, that's less attractive than buying back below book value. Right now, they're probably somewhere in the middle. Luna: So the takeaway is: don't just look at the headline dollar amount of a buyback. Look at the context — the price, the funding source, the impact on share count, and the management's incentive. Lucas: And one more thing: management's incentive. A lot of executives are compensated based on earnings per share growth, so they have a natural incentive to buy back stock to boost that metric. That doesn't always align with shareholder value creation. So when you see a buyback, ask: is this management acting in my interest, or their own? Luna: That's a great question to end on. So, Lucas, what's a concrete action a listener can take this week to apply this? Lucas: Take one stock you own or are considering, go to their cash flow statement, and compare their buyback spending to their net income over the last five years. Also, look at the change in shares outstanding. If shares have shrunk by more than, say, two percent a year on average, and the buyback was funded by free cash flow, that's a good sign. If not, you might want to reconsider. Luna: That's a simple homework assignment. And I think it's a powerful one. Lucas: Agreed. Buybacks aren't inherently good or bad. They're just a tool. The key is understanding how management is using that tool. And with that, we'll wrap up today's episode. Thanks for listening, and we'll see you next time.