In his previous paper on share buybacks, Ian Lance, co-Head of Redwheel’s Value & Income team and co-fund manager, Temple Bar Investment Trust [LON:TMPL], outlined how UK corporates could leverage low valuations to increase earnings and dividends per share.
Some of the companies that he analysed have subsequently produced strong returns supported by a total return approach to share buybacks. In his latest piece, he delves deeper into the topic to highlight that, while some buybacks are good, some are bad, and some are even ugly.
Earlier in the year, the Redwheel Value & Income team produced a paper entitled, ‘The Return of the Total Return Kings’, in which we identified two catalysts which we felt could realise the value available in UK equities: corporate takeovers and share buybacks. So far this has proved to be prescient since corporate takeovers have continued apace (with four of Temple Bar Investment Trust’s portfolio companies being targets this year alone). Share buybacks have also been a significant feature of 2024 with 50% of companies in the MSCI UK Index having bought back shares in the last 12 months. (source: Morgan Stanley, ‘The Land of Equity Yield’, 28/06/24).
Some of the companies which we argued would be big beneficiaries of a total return approach (dividends plus share buybacks) have subsequently produced strong returns such as NatWest Group LON:NWG and Barclays LON:BARC which are up 56% and 46% year to date respectively (according to Bloomberg, 25/9/24). In this article, we delve deeper into the subject of share buybacks and to make clear we do not view all share buybacks as positive.
- Not all semiconductor stocks are created equal
- Three Quick Facts: Boohoo, Airtel Africa, NatWest
- Three Quick Facts: Frasers, Dunelm, Barclays
The Importance of Capital Allocation
Probably the most important function of a CEO is allocating capital, since it will determine future returns of the business, from a menu of organic investment, acquisitions and debt repayment. Any capital deemed surplus to this can be distributed to shareholders via ordinary shares, special dividends and share buybacks. Historically, a dividend payment was the conventional way to return capital to shareholders, but buybacks have become more prevalent over the 30 years.
So, why would a company want to buy back their own shares, rather than pay a dividend?
- Dividends are sticky as companies are loath to cut them, whereas buybacks are not
- Dividends return cash to all shareholders, buybacks only to those who choose to sell
- Dividends and buybacks may have different tax consequences since they are treated as income and capital gains, respectively
- Buybacks affect the share count, dividends do not
So, if buybacks reduce the share count, it means earnings per share (EPS) usually go up, although it depends on the relative costs of debt and equity. So, the more expensive the shares, the less a buybacks works.
Buying back stock can be earnings enhancing only when the cost of debt is lower than the cost of equity. When the price/earnings (PE) ratio of equity is the same as PE of debt there is no earnings enhancement. This explains why share buybacks increased in popularity in the last decade since very low interest rates meant that some companies were able to issue debt very cheaply.
In his 1984 letter to shareholders, Warren Buffett said:
“When companies with outstanding business and comfortable financial positions find themselves selling shares far below intrinsic value in the market place, no alternative action can benefit shareholders as surely as repurchases.”
At the height of the dot-com bubble, however, Buffett warned in his 1999 letter that companies were now overpaying for their own stock.
“Nevertheless, it appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be more optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can’t help but feel that too often today’s repurchases are dictated by management’s desire to ‘show confidence’ or be in fashion rather than by a desire to enhance per-share value.”
It strikes us that with the valuation of the S&P500 at one of its highest levels ever (source: Hussman Strategic Advisers, 21/7/24), many companies are currently committing the error that Buffett had warned about in 1999. Within the S&P500, we view technology companies as some of the biggest repurchasers of shares at a time when they are arguably very over-valued.
For example, the share price of Nvidia NASDAQ:NVDA has risen by c782% since 1/1/23. Many investors were surprised, therefore, when it was announced it was going to repurchase $25bn of stock in August 2023, after the stock had trebled in the year. Interestingly, its CEO is actually selling his own shares whilst at the same time the company is buying shares. (source: Bloomberg, 27/09/24)
The idea that executives could buy back shares but only when they are trading below intrinsic value is fine in theory but more complicated in practice as it relies on first, CEOs knowing how much their business is worth, and second, on them being able to control their emotions.
So, which groups of people like share buybacks?
- Activist investors who have little patience working with management and other stakeholders to improve the fortunes of the business but instead look for quick low risk gains
- Sell side analysts citing the potential for an EPS boost, a floor under the share price and a sign of confidence
- CEOs, for many of whom, stock and options constitute a large and increasing share of total compensation
Conclusion
We continue to believe that most UK companies are doing the right thing by buying back their own undervalued stock using excess cashflow, but share buybacks must be judged as part of a hierarchy of capital allocation and therefore cannot always be assumed to be positive.
The Good
- A buyback that is part of a sensible capital allocation hierarchy
- Financed from free cash flow rather than debt
- Buying back stock which is demonstrably very undervalued
The Bad
- Buying back expensive stock
- Buying back stock whilst at the same time issuing stock to employees
The Ugly
- Using debt to buy back expensive stock when the company is already financially vulnerable