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Legg Mason, the giant asset management company that was recently sold off by Citigroup, issued a report on January 10, 2006, by Michael Mauboussin, Chief Investment Strategist, entitled, “Clear Thinking About Share Repurchases”.
Legg Mason report on Stock Buybacks
A fundamental technique of Capital Flow Analysis is to look for the motivation of market players when examining Federal Reserve national flow of funds accounts.
Legg Mason, with $8.2 billion in its own assets and $373 billion of other people’s money under management, certainly qualifies as a major player; its official views are relevant to understanding the behavior of fund managers.
The Legg Mason commentary was available in PDF format at no cost on their website in March 2006.
Rather than hedge its strong support for stock buybacks, this report boldly states that “the views expressed in this commentary reflect those of Legg Mason Capital Management as of the date of this commentary.”
In support of buybacks
Legg Mason, in this report, sets forth its fundamental position regarding buybacks:
“A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.”
I note four things about the Legg Mason position on buybacks:
- A stock is considered cheap when it trades below its “expected value”. Just what is “expected value” supposed to mean? Expected by whom? When is this value expected?
- Buybacks are considered to be an alternative “investment opportunity” rather than simply a distribution of company assets to some who wish to sell their shares.
- Legg Mason does not seem to care that buybacks are a distribution of company assets that does not go fairly to all shareholders in proportion to their holdings.
- If Legg Mason is in favor of buybacks, which hit record levels in 2005, and if buybacks signal that “no better investment opportunities” are available to American companies, why does Legg Mason continue to invest clients’ money in equities?
The general tenor of the Legg Mason commentary seems to be favorable towards buybacks, especially extremely large buybacks that are aggressively pursued and that, presumably, are more effective in jacking up stock prices and making investment managers look good.
Avarice disguised as prudent management
Since buybacks hit an all time record in 2005, but only managed to push prices up about 3%, the thrust of the commentary seems to be a complaint that management often does not carry out its buyback programs ‘efficiently’.
In other words, despite massive buybacks, stock prices were not going up as much as fund managers hoped.
Common beliefs of fund managers
The Legg Mason commentary espouses many of the old canards in favor of buybacks, as well as a few new ones:
- “The relationship between price and expected value dictates a stock buyback’s economic merits.”
- “While dividends and buybacks both return cash to shareholders, a more fundamental question looms: are dividends and share buybacks mathematically equivalent? … The methods are identical assuming the same tax treatment, no transaction costs, comparable reinvestment rates, similar timing, and an efficient market.”
- “Evidence suggests that buybacks are a more efficient means of returning cash to shareholders.”
- “Management should act as a good investor by buying the stock when the price is below the value.”
- “All things being equal, the larger the program — the higher the percentage of the shares outstanding the company actually retires — the greater management’s conviction [that its shares are under-valued]“
- “Sizable [buyback] premiums reflect management’s belief the shares are undervalued and a willingness to act.”
- “Buybacks efficiently increase the debt/equity ratio for under leveraged firms.”
For more about this subject, see my essays on “Buybacks and Options“
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