Lower stock prices can actually be good for long-term returns. When a company makes a profit and has cash to spare, it has four choices of what to do with it:

1. Invest it internally for growth

2. Acquire another company

3. Pay a dividend

4. Buy shares back (thus decreasing the number of shares it has outstanding)

Good CEO’s realise they have to choose which of the list above is in the best interests of their shareholders. Unfortunately, many do not make the right decision.

Buying shares back is an option that has the potential to either contribute to shareholder value, or greatly diminish it.

For example, in a simple 10-share company that makes $100 per share ($1000 in total) it is simple to see that if we can buy one share back for $400 then our return on this is high. Following the transaction there are only 9 shares outstanding, and each share now makes $110 per share. Buying shares back at low valuation is very earnings-accretive for the existing shareholders. But the converse is also true, if we could only buy the shares back for $2000 per share (now at 20 times earnings) the remaining shareholders get a much worse deal that destroys the value of their shares.

The following diagram explains this process:

Sharebuybacks copy

Some of the companies in our portfolio are actively buying back shares now at low prices. Although they are larger, stockmarket-listed companies the principle remains the same.

If the company can buy back shares for less then they are worth, the remaining shareholders do well.

As the share prices are lower, the return on this buy-back is even better for the remaining shareholders, although in the short term they may feel poorer due to a depressed share price. That’s why it is so important that we look at the company under the share price to see what is going on, otherwise we would lose out on this great opportunity. Some of our companies such as Discovery, Liberty Global and Liberty Media have been doing exactly that this year. So lower share prices in the short term makes us remaining shareholders more over the long term.

Disclaimer: The above does not constitute investment advice. The author has invested in the stock market and the property market at the time of writing.

Tim O'Shea
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Tim O'Shea

Fund Manager with 15 years' experience as a successful business owner-manager. Passionate about helping people benefit from the power of long-term investing.
Tim O'Shea
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Tim's Newsletter February 2016
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