The real "buyback" experience

When the tide goes out you can see who is swimming naked

There have been many debates on Twitter as to whether companies that rely on “returning money to shareholders” through buybacks produce better returns than those who distribute their surplus cash as dividends. In both cases, of course, the implied assumption is that the cash is in fact surplus to other opportunities available to the company.

The debate hinges on views about “intrinsic value”. If a company has an intrinsic value far greater than the trading price of its shares and has no higher return opportunities than its own shares (that is, its capital deployment opportunities are fully funded and the free cash flow is in fact surplus to its needs), then repurchase of shares for cancellation makes sense. It makes sense only in the “intrinsic value” estimate is within reason.

The problem for commodity based companies is that future commodity prices, on which “intrinsic value” substantially depends, is not only unknown but in reality not forecastable. With a couple of years of buoyant oil & gas prices and high cash flows, and egged on by fund managers like famed Eric Nuttall, some Canadian exploration and production companies found the “buyback” argument hard to resist. Now that recession is looming, there is a growing banking crisis, government debt in U.S. and Canada is out of control, inflation is multiples of the central banks “target ranges” and markets are in turmoil, the investment “tide” has gone out and we can see who is swimming naked. The evidence is pretty clear that it is the proponents of “buybacks” who have been exposed.

I model all the oil & gas companies in which I risk funds so it was a relatively easy matter to see what happens if oil & gas prices hit any given level, and I posted a tweet showing just how low popular names might fall if WTI falls to US$40, WCS to CAD$50, Henry Hub natural gas to US$2.00 and AECO to CAD$3.00 and it is not a pretty picture. I am not suggesting those prices are likely but they are certainly possible in a recession.

I have also reviewed the past five year “performance” of a number of oil & gas names that are popular with the #COM crowd and compared those whose management preferred “buybacks” to those whose management chose to use surplus cash to pay dividends. The different outcomes are striking. The buyback group turned in a respectable 13.5% annual return on average and all the names listed had positive returns except Crescent Point (CPG) which went sideways.

The “dividend” group outclassed the “buyback” group by a wide margin, with average returns of ~38% per year. I included Tourmaline Oil (TOU) in the dividend group despite the company’s nominal purchase of just over 400,000 shares for cancellation in the period, insignificant in light of Tourmaline’s three hundred million plus share count.

Only Bonterra (BNE) showed losses. Oddly, I see Bonterra as one of the best values today since - despite its share price falling by over 50% in five years - the company has dealt with its excess debt leverage without share dilution and is poised to benefit in the next upturn in oil & gas prices. It is vulnerable to share price weakness in the meantime, and I see that as opportunity for me to add.

The high performing companies stick to their last.

MEG has enormous reserves and has been underalued by almost any measure for years. Buybacks by MEG (once its debt was under control, or ideally eliminated) made sense and still do.

Headwater reinvested its cash flow and expanded without any debt, taking advantage of the high returns on the drill bit in the prolific Clearwater play and only recently began to pay dividends.

Pine Cliff and Tourmaline simply ran conservatively managed and profitable operations and kept their balance sheets clean while paying out regular (and in the case of Tourmaline, special) dividends when they had excess cash.

Birchcliff just paid off its debt and began a dividend of $0.80 per share, not doing anything more exciting than keeping costs under control and building a strong balance sheet. I rate that management as outstanding.

I think MEG, HWX, PNE and BIR will always do well in any environment since they benefit from sound management. I would add PEY to that list since Peyto has kept itself as the lowest cost natural gas producer in Canada which has paid off in returns.