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The case for and against share buybacks
UK companies are setting the scene to repurchase more than £8 billion of their own shares this year. Barely a year after the outbreak of Covid-19 led to a huge move by companies to protect their balance sheets and conserve cash, share buybacks are again all the rage.
Since the start of May consumer products giants Unilever (ULVR) and Diageo (DGE) have unveiled plans to repurchase approximately £2.6 billion and £1 billion worth of stock respectively in 2021. They will join a lengthening list including many of Britain’s biggest businesses in buying back their own shares this year, including Barclays (BARC), BP (BP.), IMI (IMI) and Natwest (NWG).
Share buybacks have always been a prickly issue. For ordinary investors, it is all but impossible to determine whether stock repurchases boost a company’s share price as they are meant to.
Take IMI, for example. On 26 April the FTSE 250 engineering business announced a share buyback programme worth £200 million alongside an upbeat trading update. The news saw IMI’s share price jump 11% to £15.52, and the stock has gone on to £16.50. That’s an 18% share price increase that has added approximately £660 million to IMI’s market value, more than three-times the value of the share buyback itself.
Importantly, the trading statement suggested that IMI will be funding the buyback out of cash flow rather than borrowing and management makes it clear that investment in growth, either organic or by means of acquisition, still comes first.
VALUE CREATION FIRST, BUYBACKS LAST
This is important since share buybacks should only happen if a company has nothing better to spend its surplus cash on, such as, for example, investing in new products, services, equipment, or acquisitions, which might bolster future growth.
‘If a company has taken all profitable investment opportunities, it should return its surplus cash to shareholders, allowing them to invest it in growing companies elsewhere in need of financing,’ said Alex Edmans, professor of finance at London Business School.
Orbis Investments’ UK director Dan Brocklebank believes the purchase price of a share buyback is important versus the intrinsic value of company. ‘If the share price is lower than the company’s intrinsic value, remaining shareholders benefit,’ he says.
Intrinsic value refers to the underlying value of the company and analysts typically use discounted cash flow analysis to determine this. These are complex calculations based on implied future cash flows discounted by the cost of capital, which is linked to interest rates.
In IMI’s case, its recent trading update saw Investec lift its intrinsic value per share from £15 to £17.65, suggesting that IMI’s recent stock repurchases at up to £16.43 are adding value for shareholders.
However, discounted cash flows do rely on a level of ‘butterfly effect’ supposition, or in other words, small unexpected changes in estimates can add up to huge miscalculations over time.
Sceptics argue that this leaves share buybacks open to abuse and can be used to financially engineer the impression of earnings enhancement where there has been none.
Worse, ‘buybacks create a sugar high for the corporations,’ US senator Elizabeth Warren claimed during the presidential campaign last year, boosting share prices in the short run but at the cost of starving companies of investment and, potentially, falsely inflating earnings to trigger executive bonuses.
NO EVIDENCE OF BUYBACK ABUSE
However, research commissioned by the UK Government to look at potential misuse of share buybacks among companies listed on the London stock market found no evidence of abuse. ‘Over 2007 to 2017, we found that not a single FTSE 350 firm used buybacks to hit an EPS (earnings per share) target that it would have otherwise missed,’ said Alex Edmans of London Business School and co-author of the study alongside PwC.
This builds on a seminal paper that found that firms who buy back stock subsequently outperform their peers by 12.1% over the next four years. ‘This finding is surprisingly robust,’ said professor Edmans. While the research was conducted in the US during the 1980s, a more recent study (from 2018) investigated 31 other countries and found that the results hold in most of them, he said.
‘This evidence contradicts the “sugar high” concerns but is conveniently ignored in claims that buybacks destroy long-term value.,’ said the London Business School academic. However, he does accept that ‘buybacks can destroy value in certain cases’.
MEASURING THE IMPACT OF BUYBACKS
One way to assess the long-run value of share buybacks is to look at the performance of the London-quoted Invesco Global Buyback Achievers ETF (SBUY).
It aims to match the performance of the NASDAQ Global Buyback Achievers index, a basket of firms which have reduced their share count through buybacks by at least 5% over the previous 12 months, although it is dominated by US firms (60%), with just 2% from the UK.
The ETF is up 50% from its March 2020 lows, outpacing the recovery in the MSCI World which is up by 43% over the same time-frame.
Since its launch in October 2014 the product’s price has advanced 119.7% against a commensurate 74% rise for the MSCI World.