Share Buybacks Can Be an Incredible Gift to Investors

Auto-parts retailer AutoZone (AZO) reported blowout earnings and its stock is up big lately, recently hitting an all-time high.

This reminds me of one of my greatest calls ever, when I recommended AZO to my readers on January 30, 2001.

Since then, AZO shares have risen from $26.80 to around $1,225 – an astounding 45-bagger, as you can see in this chart…

Interestingly enough, however, earnings only rose sixfold over this period – a respectable, but hardly earth-shattering performance.

So how come AutoZone’s stock went up so much more than the company’s profits?

One obvious possible explanation is that its valuation multiple could have expanded dramatically.

If the stock was trading at, say, five times earnings in 2001 and it now trades at 35 times earnings, that would explain it.

But that’s not the case. AutoZone was trading at 13 times earnings back then, and now trades at 18 times earnings… so a higher multiple is only a modest contributing factor.

So what explains it?

Share repurchases.

Today, I’ll show you why share buybacks can be an incredible gift to investors, except, well, when they aren’t… and how you can tell the difference.

I hope you’re sitting down, because AutoZone has bought back an astounding 84% of its outstanding shares since 1998. You can see it in the chart below…

As a result, while AutoZone’s earnings have grown sixfold, its earnings per share grew by 34 times since 2001.

Now, you can see that of the three possible drivers – earnings growth, multiple expansion, and share repurchases – the latter is the primary reason the stock has been one of the best performers of the past two decades.

But AutoZone didn’t always buy back its stock. In fact, as you can see in the chart above, throughout the 1990s the company’s share count steadily increased. This is typical for most businesses that grant employees options and, in some cases, use stock to make acquisitions.

Then AutoZone reversed course in 2000 and started repurchasing its stock like crazy. Every year since then, the company has bought back at least 5% of its outstanding shares.

Better yet, it has been more aggressive with repurchases during times of market turmoil when its stock was depressed. For example, AutoZone opportunistically bought back 15% of its shares following the dot-com bubble in 2001, and 12% each year from 2009 to 2011 following the financial crisis.

What caused the company to turn into such an astonishing share repurchaser?

Famed activist investor Eddie Lampert – who founded ESL Investments, which was once one of the largest hedge funds in the world – deserves the credit. In 1999, he bought a meaningful stake in AutoZone and successfully pushed the company to begin repurchasing shares.

In this case, it was a brilliant move that has rewarded shareholders handsomely. However, this isn’t always the case.

To see why buybacks aren’t always a good thing, let’s take a look at another one of Lampert’s big investments…

In 2003, he invested in Kmart and helped the big-box retailer emerge from bankruptcy. Two years later, Lampert merged it with department-store chain Sears and began savagely cutting costs to generate maximum short-term cash flow, which he used to buy back stock.

The move was a total disaster…

Starved of the capital necessary to maintain the business and compete with retail juggernauts like Walmart (WMT) and Amazon (AMZN), Sears shrank every year, lost more and more money, and, despite Lampert’s frantic attempts at every form of financial engineering, eventually filed for bankruptcy. The share buybacks incinerated billions of dollars and helped put the last nail in the company’s coffin.

The lesson here is that share repurchases only make sense when two things occur:

  • A company has true excess cash, after appropriate reinvestment in its business
  • Its share price is undervalued

Of course, both of these criteria are subjective. Lampert obviously thought that Sears didn’t need any more reinvestment. He figured that the company’s cash was better spent buying back its stock, which he believed was undervalued… So he followed the same playbook he had used so successfully since 1999 with AutoZone.

Lampert was wrong on both counts. He failed to realize that AutoZone is an excellent business, while Sears was destined for the ash heap of history.

In summary, I’m always on the lookout for companies like AutoZone, which buy back large amounts of undervalued stock, year in and year out, for an extended period of time.

Done correctly and with the right company, it can be extremely powerful – and immensely profitable for investors.

Regards,

— Whitney Tilson

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Source: Daily Wealth