Today I reached page 51 in the highly regarded personal finance book The Wealthy Barber, abruptly closed the book, and hung my head in sadness. Until this point I really liked the writer’s style and it seemed to be an interesting take on explaining investing to beginners. All was well until this passage on picking mutual funds:

“Make sure that if a fund has solid rates of return, the manager who created them is still there. You’re not buying past performance numbers; you’re buying a manager’s expertise. If fund ABC averaged fifteen percent a year under the guidance of Jack Smith, but Jack Smith left, stay away from ABC. You can’t be sure what you’re getting.”

First, picking actively managed funds is a highly frowned upon activity in these parts. We know they consistently underperform cheaper index funds.

Second, if fund ABC averaged fifteen percent per year and Jack Smith left, how can we be certain he wasn’t a DRAG on returns during his tenure, where theoretically a passive index fund could have returned something like twenty percent per year? In this case we’d have been buyers of Jack Smith’s LACK of expertise!

Third, we know what we’re getting in receiving Jack Smith’s replacement. We get the same exact risk we had when Jack was at the controls: the elevated probability our manager screws something up because he/she is an emotional, over-reactive human being capable of letting behavioral biases affect returns. It’s nothing personal: we’re all this way, and it’s always best to remove the chance of doing some stupid human thing to our portfolios. Don’t believe me? A Fidelity study showed the best performing portfolios are those whose owners forget they even had the accounts!

There are genuinely good managers out there, but finding and retaining them is a futile effort chock full of pitfalls and disappointment. It would be a huge boost to investors across the world if we could abolish this notion that superior returns can be had by simply picking the “hottest” fund managers. Investors see past returns as a Oujia board for manager selection when, instead, the reality is they’re utilizing nothing but a dartboard where only a bullseye will bring acceptable results.

Nerd alert: read on only if fully caffeinated

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What if I told you that people who comb their hair are much more confident about the appearance of their hair, compared to bald people?

You’d probably say that’s a pretty stupid comparison. I hope you’d tell me that to feel confident about one’s hair, one must have hair in the first place. (No offense to bald people – I am slowly but surely joining your club)

It turns out that many people in the financial world treat stock buybacks with similar logic. A very popular analysis is that companies with buyback programs have their shares perform better than companies who don’t repurchase their shares.

In response to this logic, my answer is, if you’ll allow: no shit!

Let’s look at some headlines:

The third headline is the most interesting to me. I believe it should read precisely the reverse. Instead, how about:

Superior Performance Delivers Buybacks

How does a company get to the point of having extra funds to buy back their shares on the open market? They perform well in their industry. They earn large profits.

Does it stand to reason that whether or not they repurchase their shares, we should see their shares outperform “non-buyback companies” or the S&P 500 in general? Yes! They’ve put themselves in excellent financial position by being good at earning profit for shareholders. Markets will reward this.

You might say in response: “But we should see how good performing companies with strong earnings but without buybacks perform in the market, versus those with buybacks.” This we agree on, for the most part.

It’s really tough, though, to complete a study of comparing the performance of companies with buybacks, those with strong earnings and no buybacks, and everyone else. The reason is that markets have so many different intangible and behavioral effects that the result of looking backwards, or backtesting results, is very tough to rely on. Investor preferences shift, regulations change, and compensation structures come in and out of favor. What happened yesterday should not have much of an effect on what we do today.

So what’s the point?

For me, a share repurchase plan is very, very low on my list of reasons to find a company attractive. In fact, I usually see it as a negative. If they see absolutely no way to reinvest cash flow profitably, see no M&A opportunities, then I’d rather see even a special dividend than a buyback (tax issues aside).

Think of it this way: an investor owns shares of a company because they expect management to use their specialty to produce positive and increasing cash flow for shareholders. This is the bedrock of equity investing.

But what happens when management is no longer just a specialist in its particular industry. What happens when they decide they are now financial analysts and portfolio managers? They might decide to buy back their own stock, you probably conclude, it’s the only one they study. It just so happens that management is also HIGHLY incentivized to boost short term returns of the stock, eschewing long-term focus, to boost their own holdings as leaders who will be in position less than a decade on average. (Thankfully this tenure number is rising)

Very few companies have rules-based buybacks in place, like Berkshire Hathaway does. I’m much more inclined to support a share repurchase if management takes a calculated, valuation-based stance. Shares trading less than book value? Go right ahead!

It boils down to this: I own shares for total return over the long-term, because the company I own is good at what they specialize in (or I see them getting better). I don’t, however, think it’s a good idea to support a habit of losing focus on competition and growth while depending on financial engineering to attract a certain class of investors. Let’s increase cash flow by playing around with the denominator, they say. Does competition scare them that much?

“But everybody’s doing it!” 

Yeah, it seems this way, and that’s not a great way to make a decision. Here’s a great example of the buyback fad: Tucows, a Canadian small-cap company, announced a buyback earlier this year. They did it curiously soon after their mobile service business (Ting) received some really bad news from a supplier.

The buyback, at $20 million dollars, amounted to over two times their cash balance at the announcement. A cynical commentator might say the buyback announcement was an attempt at softening the blow of bad news. The same commentator might mention this type of behavior is very prevalent right now. “…..but we announced a buyback!” as they frequently say in tense conference calls across the world.

Spread out over a year, or not, Tucows’ decision to repurchase shares was curious not only for the sheer size of the program. Their newest business, high-speed fiber internet, requires MASSIVE capital expenditures to get rolling. In one message they’re playing the “shareholder return” game, in another they’re touting all of their growth potential from gigabit internet. Unfortunately, the rest of their business is slowing down. Something’s going to have to give at Tucows – either growth or buybacks – and shareholders are likely going to be upset when the game of musical chairs ends.

The buyback fad can easily crowd out other potentially valuable investments, or it simply leaves a company in a more vulnerable position with low cash reserves. It takes management’s eyes off the ball and the funny logic among investors is worrying.

Buyback rant: OVER.