Is the share buyback back in fashion?

The announcement this week of share buybacks by Balfour Beatty and Domino’s Pizza, as well as plans for such a scheme at Gamesys and intentions to ask for shareholders’ permission to buy back stock at IP Group, all suggest that this way of return capital to shareholders is back in fashion.

Shareholders must now decide whether this is a sign that corporate confidence is flooding back and the good times are about to roll once more, or whether boardrooms are letting down their guard too quickly in the wake of the pandemic.

Source: Company accounts

UK-listed firms have so far announced or confirmed buybacks with a value of more than £2 billion in 2021. This includes six FTSE 100 firms – Barclays, Berkeley, CRH, Rightmove, Sage and Standard Chartered.

This is a huge turnaround from 2020 when buyback programmes with a value of more than £10 billion were scrapped and just £1.6 billion approved and carried out from March to December in 2020, after the pandemic had struck. During that time span fourteen members of the FE 100 shelved or put buyback schemes on ice (some of whom have started to act subsequently) – Ashtead, Berkeley, CRH, Diageo, Ferguson, HSBC, Next, Pearson, Rightmove, Royal Dutch Shell, RELX, Sage, Standard Chartered and WPP.

Source: Company accounts

Just a year ago, corporations were looking to preserve every penny as they prepared to face the virus and its economic fall-out. Now some clearly feel sufficiently confident to return precious cash to their shareholders.

That confounds one theory about what could have changed in the wake of the pandemic, namely company boards would abandon theories of efficient balance sheets and the primacy of return on equity and focus instead on liquidity. As a corollary of that, debt and leverage to goose returns go out of fashion. Managers would breathe more easily but shareholders would get lower profits, lower returns on equity and less dividend growth, perhaps with the result that dividends would not return to 2019’s levels for some time. As a result, equities would suffer de-rating.

This nascent trend back to share buybacks could perhaps rule out such a grim scenario and there are good reasons why firms may seek to buy back shares:

• 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 now when low interest rates mean 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 with 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.

Yet there will be some who see this rapid return to corporate largesse as a worrying sign, and one that reflects the return of animal spirits and frothy, bull-market conditions within equity markets:

• History shows companies have a habit of buying stock back during bull markets (when their stock 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 topped out in 2007 and collapsed in 2008 and 2009 only to reach new highs in 2018 as stock prices reached new peaks.
• This in turn exposes investors to the risk that management teams are buying high rather than low. That 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 buy back their stock using debt, rather than cash flow, potentially weakening their balance sheets and competitive position in the long term (although the same danger lurks with dividends).

Investors therefore need to assess the current buyback crop on a case-by-case basis, looking at how the buybacks are to be funded, the strength of the firms’ cashflows and balance sheet and the strategy behind such plans.

It is perhaps understandable that IP Group may seek permission to buy back stock after its excellent 2020, when major investments began to bear fruit and the firm paid a maiden dividend. Investors will also be pleased to see the intellectual property incubator stress that it will seek permission to buy back stock only if the shares persistently trade at a discount to net asset value. That can be taken as both a sign of faith in the company’s current portfolio of assets and financial discipline, since IP Group’s management team is not prepared to buy back stock at any price.

Such clear thought processes echo the words of 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 shareholder value through the efficient deployment of cash.
• 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, especially in managers are using cheap debt as a source of funding rather than internally generated cash.

For the moment, however, investors seem excited by the prospect of cash returns from their holdings, perhaps understandably after the thumping dividend cuts of 2020. The London-traded Invesco Global Buyback Achievers Exchange Traded Fund (ETF) has a relatively short trading history but the instrument has powered to new all-time highs.

The tracker aims to deliver the share price performance of a basket of 285 global firms which have reduced their share count through buybacks by at least 5% over the previous 12 months. Key holdings include JP Morgan Chase, Apple, Bank of America, Eli Lilly, Cisco and Qualcomm from the US; NTT, Mitsubishi and Tokyo Electron on Japan; and India’s Wipro.

Source: Refinitiv data

These articles are for information purposes only and are not a personal recommendation or advice.