Normally, I would suggest that you run away from a cannibal but a stock cannibal is one you should embrace. In a recent interview, Charlie Munger suggested that one key to investment success is to look at cannibals — businesses that consistently buy back their own shares. A company that aggressively buys back its own shares is essentially doing the heavy lifting for existing shareholders. By shrinking its share count, a company makes its profits more valuable to current shareholders because the profit is allocated to fewer shares. Ultimately, rising earnings per share will lead to a higher share price.
Sure there are those who will argue that companies should pay dividends over a share buyback and in certain cases that is true. But I’m sticking with Charlie Munger. He has the legendary track record to back up his case.
When looking for cannibals to add to our client’s portfolios, we focus on a number of criteria.
Here are a few of the key points that we look for:
1) Efficient allocation of cash – The most efficient use of a company’s free cash is to buy back its own shares when the market is undervaluing its earnings compared to its return on equity and return on invested capital. A key metric for us is P/E less than 15 and ROE greater than 15.
2) Watch the balance sheet – Share repurchases are of higher quality when free cash flow is used. Increasing debt to buy back shares can lead to a whole host of problems further down the road.
3) Growth businesses need not apply – I’m not interested in companies reducing their share counts when they are in a growth phase. The market tends to assign a higher P/E ratio to hyper growth companies. Buying back shares when the P/E ratio is well above the overall market multiple is waste of shareholder’s capital. Just look at all the capital Dell and Cisco wasted in the 90’s buying back stock when P/E ratios were sky high.
One company that fits the bill is Bed Bath & Beyond. With its hyper growth days well behind it, the company has joined the ranks of the cannibals. Over the past two years, Bed Bath & Beyond has reduced its share count by over 10% and has future plans to buy back a further $2.5 billion in stock, over 17% of its current market capitalization. The company has a pristine balance sheet with no debt and $5 a share in cash. The company is guiding for earnings per share of $5 in 2013, which means its forward P/E is 13. Bed Bath posted an impressive ROE of 25% in 2012, which means that an aggressive share buyback using all of its free cash flow is warranted.
Disclosure: Baskin Financial’s clients own shares in Bed Bath & Beyond