Morally neutral - Share buybacks are not a question of good or bad but of good or bad value
“I don’t want to know about your complicated financial engineering schemes,” harrumphed the chief executive of a large industrials business dismissively after we had suggested in a recent meeting his company might like to think about share buybacks as an alternative way of investing some of the spare cash on its balance sheet.
Buybacks are getting a bad press at the moment and perhaps this had coloured the chief executive’s judgement. Maybe he had even seen the leader in The Economist colourfully entitled Corporate cocaine and read its opening paragraph, which concluded: “There is growing evidence that the blue chips are engaged in their own kind of financial excess: a dangerous addiction to share buy-backs.”
But as The Economist later conceded: “Buy-backs are not necessarily a bad idea.” To go further, just as, for the record, share buybacks are neither complicated nor financial engineering, they are neither good nor bad. What they can be are either well-judged or badly-timed – a point to which we will return shortly – and what they certainly are at present is very popular indeed.
An FT article, The short-sighted US buyback boom, points to Barclays data showing US companies have “lavished” more than $500bn (£310bn) in the last year on buybacks. Furthermore, in the first six months of 2014, buybacks “surged” to $338.3bn, which is the largest half-yearly volume since 2007. And, yes, there would seem to be something in the subject matter that encourages picturesque prose.
Looking back, perhaps we should feel a little hurt at being thought of as complicated financial engineering schemers with its unavoidable whiff of being in this for short-term gain. Here on The Value Perspective we believe in investing for the long term – our average holding period is five years – and we also believe share buybacks can be a useful investment tool for company management.
Say you own a successful business as a sole-trader, then when it comes to deciding what to do with the cash it generates, the options facing you are effectively to take money out in the form of a dividend or reinvest it in, for example, plant or machinery. If you own the business in partnership with someone else, however, you have an extra option – to invest the cash by buying back your own equity.
Say, furthermore, your partner is a particularly excitable individual called Mr Market and one day he announces his intention to run off to Rio with your new secretary. As such he needs all the spare cash he can lay his hands on so his half of the business is yours for the knock-down price of £1,000. Do you bite his hand off? Well, we said you ran a successful business so that presumably represents a steal
Unfortunately, Mr Market dashes off for a drink with your secretary before you can get his signature on anything and the next day he informs you Rio is off because of a hitherto unmentioned husband. Now he is too heartbroken to work at the company so he is still willing to sell his half of the business – only the price has gone up a bit. What do you say to £1m?
Well, there will probably be less hand-biting but that price may still represent a good deal for you. Equally it may not but the point is this, if you are running a listed company, you have a number of options as to what to do with excess cash – you can make a physical investment in your business or you can make an investment in your own equity by buying back shares.
These options should be in competition with each other and judged on their merits and in the context of the company’s current situation. And just as no management team would blindly commit to spending a set amount a year on plant or machinery regardless of whether it was needed, no management team should blindly commit a set amount a year to share buybacks – or dismiss them out of hand.
According to The Economist, “by reducing the number of shares outstanding, buy-back schemes can also artificially boost a firm’s earnings per share” – but there is nothing artificial about it. Buying back shares can really, actually and genuinely boost a firm’s earnings per share – just so long as the firm’s managers bear three important points in mind.
First, are they putting the business’s balance sheet at risk – for example, by taking on too much debt? A lot of boards forget a company’s long-term share price is not determined by earnings, say, or free cashflow but by earnings per share, free cashflow per share and so on – and it is just as fair game to reduce the denominator in those calculations as it is to increase the numerator.
Next, company managers need to weigh up the risk of implementing a buyback versus that of other projects, such as buying new plant or entering a new market or acquiring another company. Compared with those, the risk associated with a buyback will not necessarily be higher or lower but it will be different – although at least with a buyback you will be investing in a business you already know well.
That leads neatly to the final point – that companies should only buy back shares at the right valuation. Unfortunately, history suggests corporate managers tend not to be the most natural of countercyclical investors, buying their own shares – not to mention whole other companies – when prices are too high and having share issues when prices are too low.
So here on The Value Perspective, while we may view the current enthusiasm for buybacks as a cause for concern, buybacks are not in and of themselves an inherently bad – or inherently good – thing. At a stock level, they are just one investment option that needs be assessed on the same parameters as any other – in other words, on return per unit of investment. Just because The Economist characterises them as ‘corporate cocaine’ is no reason for company bosses to be sniffy.
Fund Manager, Equity Value
I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth.
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