With almost 50% of UK stocks having undertaken a share buyback in the last 12 months, Ian Lance, co-Head of the UK Value & Income Team at Redwheel and co-fund manager of Temple Bar Investment Trust looks at share buybacks and the importance of sensible capital allocation.
He says there was a UK stock in which if you had invested £100 in 2001, would now be worth £1760 – you would think it was in the technology or biotechnology sector, but it was actually a retailer!
You may think it must have been a small start up in 2001 that grew through a series of deals like Philip Green’s Arcadia or Mike Ashley’s Fraser Group LON:FRAS. Wrong. The stock in question had its origins in a gentleman’s tailor called J. Hepworth (est. 1864, Leeds), and it had been around in its current guise since 1981 when Hepworth bought a chain of rainwear shops called Kendalls and changed its name to NEXT LON:NXT.
Using a chart, Ian details how a retailer growing at just above the rate of UK GDP could turn an investment of £100 into £1760 in just twenty years.
In summary, whilst NEXT’s sales only grew by 4.6% a year, operating leverage and good control of costs meant operating profits grew by 6.6% p.a. and the company’s operating margin expanded from 13% to 19%. The company’s net income (after its interest and tax) also grew by 6.6% p.a. But here is the clever part:
Throughout this period, the company used its surplus cash flow to buy back its own shares, meaning the shares in issue declined by 60% from 327m to 128m. As a result of this reduced share count, the earnings per share increased from 58p to 530p, which is an annualised growth rate of nearly 12% p.a. Additionally, the shareholders received an annual dividend equivalent to 3.7% p.a., turning the 11.7% capital return into a total return of 15.4% p.a.
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What can investors learn from share buyback success?
Lesson 1: Cyclical stocks can produce attractive long-term returns and if you buy them during a downturn when the share price is typically depressed, these returns can be significantly enhanced. This lesson is particularly pertinent today, as the share prices of cyclical companies are once again trading at very low valuations.
Lesson 2: Sensible asset allocation is one of the key determinants to long-term returns and the long-standing Chief Executive of NEXT, Lord (Simon) Wolfson made astute asset allocation decisions which did not involve making lots of acquisitions. NEXT maintained a strong balance sheet and financed share buybacks (when cheap) through internally generated surplus cash flow.
Lesson 3: Buying back shares can be a very sensible use of shareholders’ funds, and sometimes it makes more sense to use surplus cash flow to buy back shares than make any alternative asset allocation decisions. E.g. If a company’s share price is trading below what it considers to be its intrinsic value, buying back its own shares has one of the best risk-reward payoffs, because that company is in a better position than anyone else to estimate its own value.
The lessons outlined above are relevant to all investors. In the case of Temple Bar, the portfolio currently has significant exposure to energy and mining companies which are generating prodigious amounts of cash flow as a result of elevated commodity prices.
Despite this, the shares of these companies continue to trade on very low multiples of those cash flows. These companies have the ‘nice’ problem of how to allocate this cash flow: reduce debt, invest, pay dividends, buy back stock or make acquisitions.
Conclusion
Whilst Ian cautions CEOs about the risks of acquisitions, he and the team are closely watching those occurring in the energy sector. In their view, larger acquisitions (than BP’s of Archea) may take place in the sector, which ultimately run the risk of destroying shareholder value. They will be actively encouraging the management teams of businesses within the Temple Bar portfolio to allocate capital sensibly – discouraging acquisitions that can erode shareholder value and supporting buybacks if they can enhance long-term returns.
With the share price of many incumbent operators trading at such low valuations, the risk-reward of a share buyback looks much better to them than highly priced acquisitions in new areas. Buying back shares may be less exciting than making acquisitions but as the case study of NEXT demonstrates, sometimes boring is good.
