“The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.” - Warren Buffett
When it comes to distributing surplus profits to shareholders, management teams typically have two options – they can either pay dividends or they can buyback the company’s own stock. Deciding between the two, or indeed pursuing both, is a subject that companies can easily get wrong and one which frequently causes disagreements among investors and analysts alike.
Dividends and buybacks are ultimately designed to do similar things – reward shareholders with either a cash payment or a repurchase of stock (either via a tender offer or in the open market) which should enhance future earnings per share (EPS). In the case of dividends, where a company will typically explain its policy and then attempt to execute it, the process is very straightforward. By comparison, buybacks are rather more complicated because there are a number of variables that can influence their effectiveness and overall success (or otherwise).
A flexible way of distributing cash
On paper, a share buyback enables a company with excess cash to increase its EPS simply by buying up its own stock and reducing the number of its shares in issue. Because this has the effect of spreading the company’s profits between fewer shares, the theory is that the share price should also rise accordingly. As opposed to dividends, which generally require a long-term commitment to distributing surplus profits, buybacks can be introduced with more flexibility (subject to prior shareholder consent) and then carried out as the company sees fit.
Not only is this proving to be a popular option for companies, it has also been found to be effective. A 2002 report by Steven Young and Dennis Oswald, noted that between 1995 and 2000, the aggregate value of buybacks in the UK increased by more than 600 percent – and in the 12 months to December 2000 UK firms returned £8.9 billion to shareholders. The team argued that buybacks were drive by four factors, including: a desire to (i) distribute excess cash, (ii) counteract market under-pricing caused by high information asymmetries, (iii) maintain an efficient capital structure and hence minimise the cost of capital, and (iv) increase future earnings per share.
That research concluded that well-governed firms were more likely to disgorge excess cash while poorly governed firms were more likely to hoard (and subsequently waste) excess cash. It also found that, after adjusting for market and risk factors, share prices rise by 2 percent on average when companies announce they are considering implementing a buyback. Why the price rise? Some analysts claim that company management that introduce buybacks are signalling to the market that they think the shares are undervalued or that they have no plans to use the cash for (potentially value destructive) purposes such as new projects or M&A. In this respect, it is worth considering the views of a man that knows a thing or two about value…
Buffett on buybacks
In his 2011 letter to Berkshire Hathaway shareholders, Warren Buffett spent considerable time explaining his views on share buybacks – given that Berkshire had bought up $67 million of its own stock the previous year. He insisted that buybacks worked only when two conditions have been met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
For Buffett – who studied under legendary investor Ben Graham – buying at less than intrinsic value is a critical component of a value investing strategy. In the case of repurchasing stock in his own company, Buffett said he would buy shares at a price of up to 110% of book value. On the subject of buybacks in general, he also observed that is was essential that existing shareholders were protected: “It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value.”
Buybacks don’t have to be taxing
From the perspective of individual investors, a further point worth noting about the advantages of share buybacks is the issue of tax. This is something that has occasionally provoked criticism from some commentators, who believe that companies have increasingly used buybacks simply as a tax efficient means of returning cash to shareholders. Nevertheless, for those investors with company shareholdings that are outside a tax wrapper like a SIPP or an ISA, buybacks can frequently be more tax efficient. While the finer points of the tax implications of dividends vary depending on individual tax circumstances, with a buyback there is no share sale or capital gain – meaning that, theoretically at least, EPS should grow at no cost to the shareholder. One problem, however, is that buyback critics claim this EPS boost doesn’t always materialise because…
Companies often get their timing wrong
Companies that launch buyback programmes only to see the value of their stock fall further in the months ahead tend to attract the ire of shareholders and investment commentators. While Buffett himself conceded that “many CEOs never stop believing their stock is cheap”, research into the subject is pretty damning. Earlier this year, Thompson Reuters examined returns on stocks in the S&P 500 in the periods following buybacks and found that repurchases were ‘weakly to moderately negatively correlated with future returns’. It claimed that the majority of companies under analysis had typically timed their buyback activity poorly. Indeed, the research showed that the negative correlation between repurchases and forward returns meant that most buybacks did not pay off within the year after the repurchases.
Other factors at work
Meanwhile, critics of buybacks have pointed to other concerns. Not least, is the argument that because many management teams are encouraged to increase EPS as part of their long term incentive plans, the attraction of launching a buyback over, say, paying a dividend, is prejudiced. Academic research on this subject tends to support the theory that the surge in stock buybacks that started during the 1990s was actually triggered by a concurrent increase in the popularity of stock option schemes to compensate management and employees. In this respect, US academic Kathleen Kahlethat argues that the repurchases have frequently been designed to maximise managerial wealth – a conclusion that was also reached in similar research by Bartov, Krinsky and Lee.
Connected to this issue of stock options and repurchases is that the case for buybacks can be damaged if the management continues to issue stock whilst at the same time buying it back. Typically, companies fall in to this trap when they need to issue share to meet their obligations when employee stock options are exercised or in M&A situations. If the net effect is that more shares are issued than bought back, then the EPS-boosting effects of buybacks can be neutralised and existing shareholders can ultimately end up diluted. Unsurprisingly, analysts have debated this subject too. Among the conclusions are that companies often increase their stock repurchase programmes to take account of employee stock options in an effort to manage their diluted EPS figures.
Dividends vs. buybacks
With the increase in popularity of share buybacks since the 1990s, investors have had to weigh the advantages and potential pitfalls of how their investments distribute surplus cash resources. Meanwhile, towards the higher end of the market (and even some at the smaller end), companies are choosing to pay dividends and routinely buyback shares simultaneously. So how can income hunters adapt to this new landscape? One route is to scrutinise the Net Payout Yield – or the combined impact of dividends and buybacks minus any share issuance. Apart from that, it could well be worth heeding the advice of Warren Buffett, who believes that investors in tune with the intrinsic value of their investments will ultimately have the best fix on whether share buybacks are the most appropriate course of action.