What stocks to invest in = stock options and stock buybacks « PRACTICAL STOCK INVESTING



What stocks to invest in –

I first became aware of the crucial relationship between stock option grants and stock buybacks in the late 1990s.

I was on a research trip to San Francisco, where I had dinner with the new CEO, a turnaround specialist, of a chip design and manufacturing company with a checkered history.

In the course of our conversation, he said that one of his objectives was to ensure he retained top talent.  He went on to mention, as if it were a matter of course, that he would do so by having his firm issue enough stock options to transfer ownership of 6% of the company each year to workers (I’m pretty sure 6% was the number, but it could have been 8%).

I was shocked.

My first thought was that after eight years (six years, if the 8% is correct), there’d potentially be 50% more shares out.  This would massively dilute the ownership interest of any shares I might buy for clients.


My second was that I would have to evaluate the potential for massive positive earnings surprises that would make the stock skyrocket if the turnaround were successful, against the steady erosion of my ownership interest through stock option issuance.  (I decided to bet on skyrocket, which ended up being the right thing to do).

My third was that eventually suppliers of equity capital like me would have to question whether the kind of ownership shift this CEO was presenting as normal tilted rewards too far in the direction of management.

 

After this experience, I began to look much more carefully at the share option schemes of companies that might potentially be in one of my portfolios.  I noticed that in many cases companies had stock buyback programs–pitched as a “return to shareholders” of profits, sort of like dividends–that almost exactly offset the dilution from the issuance of new stock to employees.

This isn’t the case for all companies, but my observation is that it is for many.  I don’t think this is a coincidence.

Part of the rational for buybacks, it seems to me, is simply to prevent dilution of earnings per share, which would arguably help no one.  But at the same time, for the casual observer who looks only at share count and at earnings vs. eps, it obscures how big the corporate stock option issuance plan is.  I don’t think this is an accident, either.  Yes, the information is all in the SEC filings, but the reality is that even many investment professionals don’t read them.

That’s what I find problematic about stock buybacks–that I feel they’re misleadingly described as a shareholder benefit, while their purpose is to play down the level of key employee compensation.

 

 

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