Share Buybacks
There is certain undeserved mysticism to the share buyback. There are few greater alleged accolades than for an overview of a business to conclude with “…and they’re buying back their shares”. Therein lies an implication of double praise: not only is the company generating excess cash by the truckload, but also that management is so laudably prudent and investor friendly that it will not waste the hard-earned readies on frivolity. Management is savvy, a team to be trusted, chaps that you would invite to the golf club.
At the end of each year every company asks itself the same questions: have we made any money and if so what do we do with it? This ought not to be too vexatious, there being only a very limited number of options for consideration. The company can hoard its cash in the bank, it can invest it in some shape or form, it can pay dividends, or it can buy its own shares. It is not a long menu for consideration, it is the pre-theatre prix fixe, not the à la carte. But it is astonishing how many Boards get it totally wrong.
The rationale for the buyback is simple. If a company reduces the number of shares in issue then you, the shareholder, necessarily own a greater proportion of the remaining equity. If you follow this through to its ultimate conclusion you finish up being the only shareholder, having claim over all the company’s profits without having done anything except sit on your hands. QED the buyback must be a good thing.
There is a teeny weeny flaw in this one-size-fits-all theory. The thunder fly in the ointment being that there is nothing causal in the relationship between buybacks and the creation of value. Buying back shares that are expensive is tantamount to the wanton destruction of shareholder value.
To illustrate this let us briefly dive into investment trusts. In this 21st Century world of “discount controls” it is common, even par for the course, for investment trusts to buy back shares when they trade at a specified discount to net asset value. This makes obvious sense: the trust is buying cheap assets for the benefit of shareholders. As an example, as a result of its current discount Standard Life UK Smaller Companies trust has announced a tender offer for up to 5% of its shares and has stated it will buy back more shares at discounts of more than 10% as and when this is possible.
Contrast this approach with that of Royal Dutch Shell. In an outstanding example of a Board appearing not to understand GCSE corporate finance, Shell has committed to spending at least $25bn buying its own shares between 2017 and 2020, at unknown prices. There is no way of the Board knowing if this will be good or bad for shareholders, it is lip service to the erroneous mantra that buybacks are always a good thing.
Instead, buybacks are all too often only a good thing for executive remuneration. Buybacks raise earnings per share – a key metric for incentive-based pay – even if overall earnings are lacklustre. Cash that could otherwise have been used to invest in and grow the business is instead used to financially engineer short-term targets, regardless of the impact on long-term shareholder value.
Buybacks are a puffer fish. Wonderful in the hands of an expert, but likely to be toxic when not.
