Tuesday, February 21, 2023

In Defense of Dual-Class Stocks... And Readers Weigh in on Buybacks and Reshoring

By Herb Greenberg (View Archive)

Are dual-class stocks as anti-shareholder as they might appear to be?

In the February 16 Empire Financial Daily regarding Alphabet's (GOOGL) Google, I joked that if it hadn't been for the dual-class structure of its stock, activists probably would've been on the company's doorstep yesterday.

The very nature of the structure, with founders controlling the voting stock, makes it highly unlikely that an outsider can oust management or force profound changes.

My comments resonated with my old friend (and source) Lise Buyer, a partner at initial public offering ("IPO") consulting firm Class V Group. She's also a former tech analyst who used to work at Alphabet, where she advised on its IPO and the decision to use dual-class stocks. As she told me...

Yes, having been a part of the team that put it in place, I am not unbiased.

I disagree that the company and its common shareholders would have been better off spending tens of millions on legal fights and perhaps a proxy battle – money that generally benefits third parties and fast money more than long-term investors.

No structure is perfect and yes, like many other not-dual-class companies, it appears that Alphabet had become bloated and needed a kick in the hindquarters to make some tough moves.

Still, looking across the tech landscape it wasn't alone and dual class doesn't seem to have made any difference there.

Should vote-advantaged founders and management fail to deliver for shareholders, directors still have an obligation to force changes of one sort or another.

Dual class won't protect those who don't shape up. It does protect those that want to invest in projects that may hurt a near-term quarter or two, but should provide solid returns over time.

There's not always one right or wrong answer. There has to be a solid reason to award super-voting shares, but structured right, dual-class stock has frequently paid off handsomely for common shareholders.

As always, Lise makes great points.

Going public isn't a right... and once public, a company has to deal with everything that comes with it – including scrutiny and the possibility (if the company doesn't perform) of activists or even a board doing its fiduciary responsibility.

My view is that I don't really care about the company's share structure. Like so much when it comes to investing, if the structure is such that an activist can take a stake and agitate – great.

If activists can't do so, and you don't like that... don't buy the stock.

Moving on, there's no question that buybacks are divisive, no matter what side you're on...

Thankfully, I have smart readers who add value to the debate – such as a portfolio manager who has given this more thought than most...

"Management teams frequently ask me my preference for capital return. This is how I frame it to them.

"Buyback – an instrument through which existing holders of an enterprise increase their percentage ownership of the enterprise.

"Example: John owns 100 shares of XYZ that has 1000 shares outstanding. XYZ buys back 100 shares. Previously John had 10% (100/1000) of the enterprise. Now he has 11.1% (100/900) ownership. In the long run, John [ends] up owning a higher and higher percent of the enterprise.

"Dividend – an instrument through which existing holders of an enterprise divest their exposure to the enterprise.

"Example: John invests $100 in XYZ and receives a $5 dividend. Every time he receives a dividend, John reinvests the $5 in ABC corp. Over time, John's investment dollars are moved from XYZ to ABC.

"If a company's prospects suggest their equity will outperform the market in the long run – buyback is the choice.

"If a company's prospects suggest that their equity will underperform in the long run – dividend is the choice.

"The reason to use both is that dividend dampens volatility.

"John invests $100 buying 20 shares of XYZ at $5 and XYZ pays 20 cents a share dividend, a 4% yield. XYZ grows their dividend at 15% [compound annual growth rate] CAGR along with their earnings. After 5 years the dividend is 40 cents, after 10 years the dividend is 80 cents for a yield on initial investment of 80/500 = 16%.

"After 10 years John's yield on the stock is so good, even if the stock is flat for the next five years, he will hold it. If the company paid no dividend, he would be more prone to sell the stock and reinvest elsewhere.

"Similarly if the stock falls, the yield increases, attracting new investors and making it more costly to be short. When an investor wants to short a sector, they should have a preference for shorting the stocks in that sector that do not pay a dividend, because it costs less to be short them.

"There are a few management teams that really get this. You can see how as the business matured, Home Depot raised their dividend payout ratio. If you bought HD at $53 in 2012 you collected $7.60 last year, benefitting from [earnings per share] EPS growth and a 50% increase in payout ratio, you now have a 14% yield and your % ownership of the company is up 66% due to buyback. Hope this helps." – Sam S.

Herb comment: Sam, excellent explanation... I can't thank you enough. Nothing better than seeing the two-fer.

From other readers...

"A company should only buy back its stock when it is undervalued. Too many people and too many companies think that it is a no brainer to just buy back their stock. Not so, as you have pointed out. I get so irritated at Boards of Directors and top management that buy back their stock when it is NOT undervalued and make fools out of themselves and no one calls them out on it.

"Take for example Target Corporation. A year ago they made $7.3 billion in earnings. They spent all of that and borrowed money to buy back $9.2 billion of their stock which then became $2 billion under water. Now they are floating bonds to replenish their capital which will incur millions every month in interest. Goldman Sachs is their investment banker and I suspect that they might have suggested doing this to the Board, which is a bunch of ignorant people collecting their fat fees.

"Of course, Goldman Sachs would have done great, earning all those commissions and the ignorant Board swallowed it hook line and sinker. Target must be the company of $2 billion blunders (re: flop in Canada by a CEO who was suggested by the previous CEO and never worked anywhere other than Target). As to the integrity of Goldman Sachs, read Greg Smith's book 'Why I left Goldman Sachs.'" – Ted C.

Herb comment: Ted, Target (TGT) is a perplexing one because the company has bought back roughly half its shares over the past 10 years – consistently, in fact – until that big purchase last year... which in retrospect looks boneheaded. Target also pays a dividend. (See Sam's comments above.)

A bull could easily argue buybacks have been a win because even with the recent setback, Target's stock is multiples higher than it was 10 years ago, when the buybacks accelerated. The same goes for its financial performance and its free cash flow, which was fine until the past three quarters when it turned negative – and not by a small amount.

At the same time, to your point, Target's net debt leaped – likely the result of that last round of repurchases, which as it turns out were at the peak. Now with its stock down, as of its third-quarter 10-Q, the company said it was taking a "very cautious" approach to buybacks.

In other words, when Target shouldn't have been buying, it did... and when it should be, it can't. Not a good look.

"Hi Herb, I think the criticism of buybacks stems from the fact that sometimes companies that provide critical goods and services buy back shares when their balance sheets are weak. And when crisis hits they receive government bailouts that don't always get paid back.

"Granted the conversation around buybacks often shows misunderstanding of what they do and who benefits. I won't fault Apple or Berkshire for buying back shares. But what if airlines begin buybacks again without first shoring up their balance sheets? From what I understand they received billions that aren't expected to be paid back to the government. That would seem wrong to me. Let me know your thoughts." – Roland D.

Herb comment: Roland, no argument here. And with airlines specifically, I find it hard to believe that right now, aside from making sure the balance sheets are "in compliance," there will be a better use of cash than reinvesting in the business. The 2020 buybacks were a weird point in time.

"Hi Herb, it's definitely interesting to read about how these buybacks can be used poorly in some cases (such as for Bed Bath & Beyond). What's also interesting to me is how growth-oriented (or maybe tech-oriented) companies seem to use it more often, and I'd be curious to know if there's a general point at which companies might decide to switch between having dividends and doing more buybacks." – Greg M.

Herb comment: Greg, see Sam's comment above.

"I've never been able to spend any cash from buybacks. I can spend real cash from dividends. End of story." – Marty W.

Herb comment: Well, Marty, the contra point would be if the stock ultimately rises more than it would have with just dividends, you would possibly make more when you sold the stock. On the other hand, if you're relying on "income," I agree... Buybacks aren't going to help.
"Brilliant note in simplicity and directness... political pandering and bad policy... what's new." – Jeffrey S.

Herb comment: Thanks, Jeffrey. No matter what side of the political spectrum you're on, that's not going to change. Never. Ever.

Meanwhile, the February 13 Empire Financial Daily with comments on reshoring also drew feedback from readers, but with an interesting theme...

Here are some of the responses...

"RESHORING – I think a lot of industry will relocate to Mexico and then ship up north. But how do you get up north from Mexico? West of the Mississippi the only reasonably priced route is by rail. There are no waterways or Rte 95s. Canadian Pacific is sitting pretty. I wish it were cheaper!" – M.R.

"I would say a logical call would be companies that relocate in northern Mexico. There is real estate and people. The companies should set up schools to train the workers. The companies would have a trained labor force with minimal supply issues and lower transportation costs. Mexico will have the new increase in population. Thanks Herb, I like your insight on companies." – Jim W.

Herb comment: Thanks, M.R. and Jim. It's fascinating that you both picked up on the Mexico part of the story, which should benefit several railroads – Canadian Pacific Railway (CP), yes... but also Union Pacific (UNP), which has a 26% stake in Mexican rail consortium Ferromex. Truckers and the intermodal industries will also benefit.

There's a twist to that story, though...

As much as part of the shift to Mexico (and the U.S.) is to flee from China, as the New York Times recently reported, Chinese companies are investing billions in Mexico with the goal of not losing all of that business. Bottom line – it's still reshoring... and its fallout (in a good way) will filter through the U.S. for years.

If you have anything to add to the discussion, I want to hear it... Send me an e-mail by clicking here. I look forward to hearing from you.


Herb Greenberg
February 21, 2023