A topic that is hotly debated between investors and the companies they own is whether "excess cash" is best returned via dividends or via share buybacks. With Halfords (LON:HFD) AGM coming up, and Halfords being a major component of my high yield portfolio, I need to take a view on this. Of course, where management and investors are agreed that significantly better returns can be generated by re-investing the cash in the business - either via investment for organic growth or by acquisitions, then clearly that is what should be done, but that is not always the case. "A bird in the hand being worth two in the bush" should also be borne in mind, i.e. a cash return is risk free whereas there is risk attached to reinvestment, from investors' POV.
There are certain special cases that I won't discuss here: e.g. investment trusts buying back shares for discount control. My investigation/conclusions relate to trading businesses.
Up until now, my view has been that buybacks can be justified - but only where shares can be bought sufficiently cheaply. I thought I ought to do some analysis to see whether this view is valid and what "sufficiently cheaply" is. For the purposes of my analysis, I imagined a business that is not growing but generates static post-tax earnings of £100m p.a.. I also assume that 50% of these earnings are distributed to shareholders. I then consider two cases over a 5 year period. In the first case the distribution is entirely in the form of dividends. In the second one, the company decides to distribute 25% as a dividend and 25% in the form of buybacks. Further, in the second scenario, I assume that the company's shares trade on a P/E of 8 throughout. Here are the results of this analysis:
|Shares in Issue (m)||100||100||100||100||100|
|Shares in Issue (m)||100||97||94||91||88|
|Share Price (p)||800||826||852||880||908|
|Shares bought back (m)||3.13||3.03||2.93||2.84||2.75|
The ultimate metric is total shareholder return (TSR). In the "dividend only" case, this is 250p/share over the period considered, comprising the dividend only. In the buyback case, the TSR comprises the sum of dividends and the difference between the initial and final share price (assuming a constant P/E), which totals 146.9p. Though in the very long term buybacks may result in a higher return, over a sensible forecasting period shareholders are clearly much better off with a simple return of cash. A cash return also offers the option of dividend reinvestment, to increase the investors' interest in the business, if he/she finds the shares offering good value.
So, how low does the P/E have to be for the buybacks to actually generate a better TSR? I found that it has to be as low as 2!
There are some other factors that may influence the decision on whether to institute buybacks or just pay a higher dividend:
- Tax considerations. For a higher rate taxpayer, there may be a greater benefit than I have illustrated in receiving some of the return through a capital gain rather than a dividend. However many institutions or individuals have their shares in tax sheltered account, so that isn't a factor. My understanding of current corporate taxation is that it makes no difference from the issuers point of view.
- Share price stabilisation. A buyback programme is likely to reduce share price volatility, as it means that there is always a buyer in the market. That may appeal to shorter term investors and to fund managers (who worry about nonsense such as "alpha" and "beta"), but from the long-term value investor's perspective, that is no benefit at all, and reduces opportunities to pick up shares at attractive prices.
Of course, it also allows managers to turn a no-growth business into one that appears to be growing its EPS (but isn't really adding any economic value at all). That might help achievement of bonuses.
Based on this analysis, I shall vote against Halfords' decision to return £75m of cash in FY2012 through buybacks, vs £44m in the form of dividends: I'd much rather have a 50% higher cash dividend, which should be easily affordable.
The author may hold shares in this company, all opinions are his own and you should check any statements that appear factual and not rely on them before making an investment decision. The author is NOT a qualified analyst nor authorised to give investment advice. Whilst the author is a director of ShareSoc, all views expressed are entirely his own and not necessarily those of ShareSoc.