Share buybacks: pros and cons

If a firm has a strong competitive position, which in turn grants it pricing power, there is a fair chance that the company will be able to generate consistently good operating margins and cash flow and therefore be able to return cash to investors.

And ultimately it is the ability to return cash to shareholders that separates share certificates from baseball cards, stamps or any other investment. As American billionaire, sports team and TV personality Mark Cuban once put it: “I believe non-dividend stocks aren’t much more than baseball cards. They are worth what you can convince someone to pay for it.”

That rather sounds like the Greater Fool Theory and although Cuban has made his preference for dividends clear, companies have two mechanisms available (or perhaps a combination of the two) when it comes to returning cash to their shareholders.

• Dividends
• Share buybacks

Given announcements this week from both FTSE 100 real estate investment trust British Land and FTSE 250 plastic packaging expert RPC Group now seems like a good time to revisit the case for (and against) share buybacks, especially as the share price of both firms initially responded favourably to the cash return plans.

The case for share buybacks

There are four strong arguments in favour of buybacks.

• If a company is generating surplus cash it can return it to shareholders and let them decide what to do with it, rather than splurge it on an unnecessary acquisition or capacity increases. This is a particularly acute issue at the moment when record-low interest rates means that firms are not gaining a decent return on any cash holdings.
• Buybacks can work for individuals depending on their tax situation, and whether they prefer to be taxed on a capital gain (buyback) or dividend (income).
• Anyone who elects to retain their shares if a firm buys back stock will have an enhanced stake in the company and thus be entitled to a bigger share of future dividends (assuming there are any).
• They can also suggest that a management team feels a company’s shares are undervalued, so any move to buy back stock can be seen as a vote of confidence in the firm’s near and long-term trading prospects. HSBC’s announcement of a $2.5 billion buy back in August 2016, alongside what looked like pretty ropey set of second quarter figures, helped to spark a recovery in the stock that has continued to run strongly ever since:
  

HSBC’s August 2016 share buyback announcement helped the share price a lot

Source: Thomson Reuters Datastream

The cash against share buy backs

However, not everyone likes buybacks – and potentially with good reason.

• History shows companies have a habit of buying stock back during bull markets (when their stocks tends to be more expensive) and not doing so during bear ones (when their stock tends to be much cheaper). For example, buybacks in the US peaked in 2007 and collapsed in 2008 and 2009 only to accelerate again in 2011 and 2012.
• This in turn exposes investors to the risk management teams are buying high rather than low could therefore question whether executives are sufficiently objective when they sanction a buyback to show the market they feel their stock is undervalued.
• A buyback could be used to massage earnings per share figures by reducing the share count at limited cost. This could be used to trigger management bonuses or stock options.
• There is also the risk that firms buyback stock using debt, potentially weakening their balance sheets and competitive position in the long term (although the same danger lurks with dividends). This does not look to be the case with RPC, at least.
• Ultimately, buy backs do not always work. BP’s website shows that the firm has spent $61.4 billion on share buybacks since 2000 but its share price now is lower than it was 17 years ago. In addition, analysts are now fretting over whether the firm is going to be able to sustain its dividend payment for too much longer if oil prices stay depressed (other than by damaging itself in the long term by taking on debt or selling assets at potentially low prices).
  

BP's share price now is lower than it was 17 years ago

Source: Thomson Reuters Datastream

Comparing the chart above with the one below also rather suggests that BP spent more on buybacks in 2000-2001 and 2005-2007 (when it shares were high) and a lot less (or none) in 2002-2003 and 2010-12 (when its shares were depressed, although the Gulf of Mexico disaster explains the latter period):

BP’s extensive share buybacks have ultimately done little for the stock price

Source: Company accounts

Conclusions

When it comes to buybacks, it may therefore be worth heeding the words of master investor Warren Buffett from his 2012 letter to shareholders in his Berkshire Hathaway investment vehicle.

“Charlie [Munger] and I favour repurchases when two conditions are met: first, a company has ample funds to take care of the operational liquidity and needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated.”

Bearing this in mind, investors must therefore look at how a company buys back its stock.

• If it does so in a disciplined manner, clearly setting a maximum price that it is prepared to pay (and explaining why) then the buyback could help to create share holder value through the efficient deployment of cash. Next used to be particularly good at this – although this well-run retailer bought back stock at prices as high as £68 a share in January 2016 and last bought them back at £45.78 in October. Next’s shares currently trade at £37 to suggest the buyback has done investors little good, at least in the near term.
  

Next has stopped buying back stock – after a sharp fall its share price

Source: Company accounts

• But if a company buys shares at any price – something that could get a professional fund manager the sack for poor performance and do damage to any private investor’s portfolio, since the price and valuation paid for a stock are the ultimate arbiter of the long-term return they make from an investment – then its buyback programme should be treated with scepticism. Such indiscipline would raise suspicions that management is simply trying to massage the share price or earnings targets or both.
  

Russ Mould, AJ Bell Investment Director