Share buybacks return to the spotlight
Japan has become more shareholder-friendly over the past few years with companies handing back spare cash via higher dividends. This process has naturally extended to share buybacks, as evidenced last week by Sony declaring its first ever buyback.
Although Sony’s actions boosted its share price, buybacks polarise investors for several reasons.
WHY DO COMPANIES PURCHASE THEIR OWN SHARES?
Companies which generate cash typically reinvest that money in their business. Any excess cash is often returned to shareholders in the form of dividends or share buybacks. The latter can involve a tender offer where shareholders apply to sell some of their holding to the company, or the company simply buys stock in the market.
WHAT ARE THE PROS OF BUYBACKS?
Investors who hold shares outside of a tax-efficient wrapper like an ISA would pay less tax on selling their shares via a buyback than they would from receiving the cash as a dividend.
UK residents on the higher-rate tax band would pay 20% above their £11,700 annual allowance for capital gains (i.e. selling shares at a profit) versus 32.5% above their £2,000 annual allowance for dividends. The downside is that not everyone wants to give up some or all of their investment by selling.
A company announcing a share buyback effectively becomes an active buyer in the market, potentially pushing up the share price as long as investors don’t all rush to flog their stock.
Cancelling stock acquired through buybacks means that remaining shareholder should be entitled to a bigger share of any dividends
in the future.
WHAT ARE THE CONS OF BUYBACKS?
Buying back shares for cancellation also artificially improves earnings per share as the number of shares in issue is reduced. Management bonuses and stock option awards are often linked to earnings per share – undertaking a buyback can be an easy way to hit the target.
It is possible that companies underestimate ways in which they can reinvest cash to improve business efficiency longer-term. While buybacks can reverse a falling share price, a company should base its decisions on the strategy of the business, not a share price. They may be better off spending that cash internally where the longer-term benefits could ultimately reward shareholders.
However, there is a risk that companies fail to generate decent returns off such investment which would be negative for shareholders.
Tax cuts in the US have fuelled a spate of share buybacks. Critics say firms would be better off reinvesting the tax savings in their business as it could help boost the economy.
Senators Chuck Schumer and Bernie Sanders, both Democrats, last week proposed limiting the ability of corporations to buy back stock and suggested possible changes in the tax treatment of investments. Historically buybacks were discouraged by the Federal government – until changes in 1982 when regulations were loosened by the Securities and Exchange Commission.
While we could debate this subject matter across a much longer article, what truly matters for shareholders is that companies give deep thought to how they spend their spare cash and not simply do buybacks because that’s in fashion or for management’s personal gain.
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