A common theme among many of our portfolio companies is that management is opportunistically allocating excess capital toward the repurchase of shares. While capital allocation one of management’s most important responsibilities, many CEOs focus solely on their operating businesses and fail to allocate capital effectively. In our portfolio, we hold a number of companies with managements that have demonstrated a strong understanding of capital allocation. This is not by accident; it is part of our selection process. In the most recent quarter, Group 1 Automotive, Jefferies Group, Synchrony, and HCA all actively repurchased significant amounts of their own shares.
While most all investors intuitively understand dividends, buybacks are a less well understood by the investing public. Dividends are instantly gratifying but insufficient. Share buybacks are a tax-efficient way in which companies can return cash to shareholders. In fact, the double taxation of dividends should make it preferable for investors that companies buy back stock rather than pay a dividend. If you own shares of a company that you think is undervalued, buybacks also increase intrinsic value per share by definition.
Income-oriented investors often prefer dividend-paying companies, but share buybacks provide investors the ability to create a homemade, tax-free dividend. By selling shares in proportion to those purchased and retired by management an investor can receive a cash flow (from the sale of shares) while maintaining his same proportionate ownership in the company. The only tax payable on the transaction would be capital gains tax on any gain in the sold shares. And not only is the tax rule on capital gains lower than that on ordinary income, the cash proceeds of the investor’s sale of shares avoids taxation at the corporate level, as well.
When assessing the effectiveness of a repurchase program, investors should favor those companies that repurchase shares only when their stock is trading below its fair value and when no higher return investment opportunities are available. More often than not, managements tend to buy high rather than buy low, so management with a value-oriented mindset is needed to take advantage of undervaluation. At extreme points on the valuation continuum, management can act on its conviction by being bold with its buyback program and buying back a substantial percentage shares. We witnessed this recently when one of our portfolio companies, Jefferies Group, repurchased more than 7% of its outstanding shares during a single quarter. In another case, Group 1 Automotive has repurchased 5.5% of its outstanding float since the beginning of the year. The company also provided commentary during its most recent quarterly call on the attractive proposition of its own stock and highlighted plans to continue to repurchase shares as the current low valuation (8x earnings) implies a compelling investment opportunity.
HCA’s ongoing share repurchase program highlights the effective use of opportunistic share repurchases for long-term value creation. Since 2011, the company has retired roughly 30% of its outstanding shares. If HCA had produced no earnings growth since 2011, the company’s earnings per share would have increased 42%. Combine share retirement of this magnitude with even moderate earnings growth and the long-term results can be impressive. The combination of single digit revenue growth, modest operating leverage, and aggressive share repurchase has allowed us to increase our estimate of HCA’s business value by 25% over the past 18 months. The stock’s price has also responded favorably, increasing roughly 50% from our average purchase price in June of 2017.
Greenlight Capital is a reinsurance firm run by another value-oriented manager that has recently seen investment results fallen out of favor. While we have adjusted our valuation downward since our purchase, the company currently trades well below its fully adjusted tangible book value of $17.40 per share, which could be liquidated and sent to shareholders, were the company to dissolve itself. As investment results improve over time, the company should return to trading at a material premium to book value like the majority of its publicly traded peers. The company is intent on narrowing this discount and recently announced a convertible offering in order to repurchase shares at a discounted valuation. The company’s insurance underwriting continues to improve and the sub-100% combined ratio and the inherent leverage from the insurance float should allow the company to compound book value by double-digits annually, if the investment results return to anything near their historical levels.
Important disclosure: Nothing in this post should be considered a recommendation to buy or sell any securities. Nor should it be considered representative of the stocks in our portfolio at any time, nor should the performance of any of the shares mentioned be considered representative of the performance of any other of our portfolio companies or of our portfolio in total. We may or may own shares of companies mentioned in this piece. Our opinion about these companies, if any, are subject to change without notice.