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Monday, June 28, 2021
The National - Are share buybacks destroying your wealth?
Vijay Valecha, Special to The National June 28, 2021
One of the strangest things that companies can do with their surplus cash is to buy their own shares, and right now they are going on a shopping spree.
Just as many people are sitting on a lot of cash following last year’s lockdowns, so are many businesses and a growing number are choosing to spend the money on share buybacks.
Technology company Apple has authorised a thumping $90 billion to its buyback programme this year.
By early May, US companies had bought back more than $500bn of their own stock, the highest figure in more than 20 years, according to Goldman Sachs.
It seems an odd thing to do. Shouldn’t businesses be investing surplus revenue profits in future growth or dishing up dividends to loyal investors?
Share buybacks remain controversial, but popular. Most programmes were scrapped in the early stages of the Covid-19 pandemic, so many investors are celebrating this year’s resurgence. Or are there darker motivations at play?
Companies reward long-term investors in two main ways. First, by paying dividends. Second, by purchasing their own stock.
In a share buyback, a company takes a pile of its own cash and reinvests in itself, says Chaddy Kirbaj, vice director at Swissquote Bank.
“With fewer shares on the market, the percentage of the company each existing investor holds should rise.”
Companies may also buy their own shares if they believe the market is undervaluing them, he says.
“By picking up their stock at a bargain price, management can demonstrate confidence in its long-term trading prospects, sending a positive message to financial markets.”
Last year, Warren Buffett’s Berkshire Hathaway investment vehicle bought back a massive $25bn of its own stock and it has spent another $8bn so far this year.
Charlie Munger, Berkshire Hathaway’s vice chairman, once called buybacks a “highly moral act” if done when shares are trading at a bargain price as this rewards shareholders. However, he cautioned that they are “deeply immoral” if executives repurchase shares solely to drive up the price.
In the UK, about 35 listed companieshave announced share buybacks totalling £8.8bn ($12.3bn) this year, including a hefty £2.6bn from household goods company Unilever and £1bn from Diageo.
This follows a tough 2020, when £10bn of buyback programmes were scrapped between March and December, and only £1.6bn were approved, Russ Mould, investment director at online investment platform AJ Bell, says.
During the first Covid-19 lockdown last year, companies scrambled to preserve every penny, now they are feeling more generous, he says.
“Shareholders must decide whether this is a sign that the good times are about to roll or boardrooms are letting down their guard too quickly,” he says.
Critics argue that a successful company should be ploughing its profits back into the business to generate further growth, but Mr Mould says this is not always the best strategy.
“Share buybacks can make more sense than splurging spare cash on, say, an unnecessary acquisition or pointless capacity increases.”
Returning money to shareholders may also be better than leaving it in the bank, where cash now generates a near-zero return.
It also rewards long-term shareholders for their loyalty.
“As well as driving up the share price, it gives them an enhanced stake in the company and a bigger share of future dividends,” says Mr Mould.
If a company has sufficient liquidity to cover its operations and its stock is selling at a discount to the underlying value, buybacks can make sense.
Yet, senior executives have a strange habit of buying their own stock when it is relatively expensive.
US buybacks peaked at $433bn in 2007, shortly before the financial crisis when markets were flying, and crashed in the aftermath. They hit $439bn in 2014 and peaked at $566bn in 2018, US Federal Reserve data shows.
Instead of taking advantage of undervalued share prices, executives seem to get carried away by overvalued ones.
“Some will see today’s rapid return to corporate largesse as a worrying sign, reflecting today’s frothy markets,” says Mr Mould.
It is odd that so many companies are buying back their shares when markets are booming, says Paul Jackson, global head of asset allocation research at fund manager Invesco.
He says this is “justified mainly by distortions”.
The first is tax. Effectively, a buyback should hand investors a capital gain in the shape of a higher share price. By contrast, paying dividends gives investors income.
“In many countries, including the US, capital gains are taxed at a lower rate than income. So, shareholders may be better off than if they received a dividend,” says Mr Jackson.
Second, shareholders are not the only ones to benefit from a generous buyback. Senior executives may as well.
All things being equal, buybacks should boost earnings per share by reducing the total amount of shares issued. Many company board members have remuneration packages linked to earnings per share performance and, therefore, reap the rewards.
The danger is that many buybacks are funded by issuing debt, a temptation given today’s low interest rates, Mr Jackson says.
“Another attraction is that interest costs are tax deductible, while dividends are not.”
However, if interest rates rise, that debt could prove costly to service. If the buyback was financed from surplus cash instead, the business will generate less interest. Those issues could come into focus if inflation forces up interest rates.
Tax incentives further distort decision-making.
“Eliminate them and I believe the popularity of buybacks would evaporate,” says Mr Jackson.
There is another distortion. Bankers and brokers make big money from organising share buybacks and their fees come at the expense of shareholders.
“Further, reduced cash balances and higher debt burdens reduce operational flexibility, which could be a problem in a time of crisis.”
Another concern is that management time spent on this financial engineering could be better spent on more profitable activities, says Mr Jackson.
“Governments could boost business productivity by removing the tax distortions that push companies to spend so much time, energy and money on these programmes,” he says.
Right now, few investors will be complaining. Instead, many will be actively seeking companies offering generous share buyback programmes.
Companies on the SPX Buyback Index, which tracks the top 100 stocks on the S&P 500 with the highest buyback ratios, has delivered an impressive average total return of 12.27 per cent a year since 1994.
That is notably higher than the 8.14 per cent average across the S&P 500 index.
“Scrapping a dividend causes more reputational damage than stopping a buyback, even though both have a similar impact on shareholders.”
For now, investors seem excited by the prospect of getting cash from their holdings, Mr Mould says.
“This is understandably after the thumping dividend cuts of 2020.”
A simple way to take advantage is to buy the Invesco Global Buyback Achievers exchange-traded fund, which tracks a basket of 150 global companies that have reduced their share count through buybacks by at least 5 per cent over the previous 12 months, he says.
Key holdings include Oracle, Intel, eBay, Biogen and HP from the US, Japan’s NTT and Tokyo Electron, and India’s Wipro. The trust is up 36 per cent in the past year and 110 per cent over five years.
Share buybacks may seem odd and do not guarantee success, but many are happy to see them make a swift comeback.