Trading your own equity
By definition, value oriented investment processes seek to derive a fundamental valuation of a company independent of its market valuation – end game being to identify a mismatch between the two. What is often ignored in this process is that the trading price of a company’s shares is in itself an important attribute that can enable real financial value creation for shareholders.
A company’s shares can in fact be viewed as a form of currency that fluctuates in value over time. In turn, a company can actively trade this very currency against the market – by either selling new shares in itself to the market or buying back its own shares from the market.
An oft celebrated case study is Teledyne, managed by Henry Singleton, where he acquired 130 companies funded mostly via the issuance of Teledyne’s highly valued shares (ranging from 20x to 50x) during the conglomerate boom. Eventually the market soured against conglomerates and Teledyne lost its high valuation multiple. In response, Teledyne aggressively repurchased 90% of its own stocks between 1972 and 1984 over 8 tender offers.
Teledyne’s average stock issuances was at over 25x; in contrast, the average for his repurchases was under 8x.
Teledyne delivered a phenomenal compounded return of 20.4% p.a. for its shareholders between 1963 to 1990 (vs. 8.0% for the S&P 500 over the same period).
So rather than being subject to the schizophrenic nature of Mr. Market, Singleton subjugated Mr. Market to his own advantage.
Let’s further explore this concept in the modern ASX context through some case studies – BWX Ltd (BWX), Domino’s Pizza Enterprises (DMP) and MYOB Ltd (MYO).
Selling your own shares
BWX has been a phenomenal performer on the ASX since listing at $1.50. After 2 short years as a listed company (and 4 acquisitions), its prospective earnings per share have increased from $0.12 per share to over $0.25 per share today and its shares now trade at close to $7.00.
How did BWX achieve a more than 4 fold increase in its share price over a period of 2 years? It did in fact sell more widgets, but certainly not 4 times as many.
There is a much more powerful value creation process at play here and this is how it works.
Firstly, you put forward a narrative to the market that you are a fast growing company with a world-beating earnings margin, strong tailwinds and incredible blue sky ahead (shortcut being to piggyback onto successful pre-existing market narratives). You then reinforce this narrative by acquiring along your own value chain – steepening your earnings trajectory and ensuring that the market buys into the sustainability of your margins. Importantly, you don’t need to convince the entire market of this narrative but just a sufficient number of marginal price-setters.
Once a high valuation multiple is achieved, you can then trade it in for incremental earnings – either by paying for acquisitions using your own shares as currency or, if vendors won’t accept your shares, selling new shares to the market to fund the acquisitions.
Assuming you trade on a high multiple, issuing new shares at a modest discount to fund an acquisition becomes a win-win for all stakeholders involved – vendors realise a blockbuster valuation for their companies, participating shareholders book an immediate profit on their new shares, brokers and bankers get to clip another juicy ticket. All this is supported by an actual increase in earnings per share.
The key here is that the company’s highly priced shares enable it to purchase earnings from the private market at a much lower valuation relative to its own valuation. Essentially you are buying earnings from the private market and re-selling it to the public market immediately, booking the difference as a step-increase in earnings per share (essentially a trading profit).
The bull case is that this type of value creation can continue indefinitely as long as the market narrative holds up and new acquisition targets can be found. The high valuation multiple enables the company to find more acquisitions with lower relative valuations and also sell shares to fund them, which in turn increases earnings per share, which further reinforces the high valuation multiple – thus completing a self-reinforcing cycle.
It is important to note that this particular value creation model is not in any way unique to BWX and its underlying mechanics lie at the foundation of many acquisition-driven listed growth companies. This model thrives in a bull market.
Buying your own shares
What is much more difficult to execute in the Teledyne playbook is to then buyback your shares at low multiples.
DMP and MYO are both highly-shorted battleground stocks currently in the midst of on-market share buybacks to the tune of $300m and $100m respectively.
These share buybacks are being conducted under the auspices of “returning capital to investors” despite the fact that both companies already carry a solid quantum of debt and trade on top-of-the-cycle earnings multiples.
Nonetheless these share buybacks have the effect of immediately increasing earnings per share (i.e. earnings accretive) simply because cheap equity is being replaced with even cheaper tax deductible debt in the capital structure. Simultaneously a non-organic buyer for the shares with deep pockets is introduced into the market (which certainly doesn’t hurt the share price!).
There is certainly a case to be made that excess capital should be returned to investors if the company cannot find avenues to deploy the capital at adequately high ROICs. However, when supposed growth companies with long runways are buying back its own shares at ROICs below 5%, then one could question whether these are indeed prudent long-term capital allocation decisions. A cynic may view them more as open-ended share price maintenance initiatives conducted with the shareholders’ own capital.
EPS increases are not all created equal
Whether it is BWX selling shares in itself or MYO /DMP buying shares in itself – an immediate increase in Earnings per Share is achieved for shareholders. Mechanically, BWX achieves this by buying earnings from the private market and re-selling them to the public market at a higher valuation while MYO and DMP achieves this by replacing its already cheap equity funding with even cheaper debt funding.
Qualitatively though, these are a very different type of increase in earnings per share to the old school way of simply selling more widget or making more money on each widget. As prudent risk mitigating investors, the key is to then clearly discern the real sources of value creation and most importantly recognise and understand the very conditions that sustains this value creation.
Note: The above article constitutes the author’s personal views only and is for entertainment purposes only. It is not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold short positions in DMP and BWX at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION. Any positions held by the author may, for example, be part of a pair trade or a hedging position so they are not informative in isolation).