Share buybacks, or the repurchase of shares by listed companies is a popular use of listed companies’ cash. Repurchased shares are initially held in treasury which means they do not qualify for dividends or voting rights. If treasury shares are subsequently retired, this provides a stronger signal on the intentions of management. From the long term shareholder’s perspective, a buyback is viewed positively because the reduced share count increases all other shareholders’ percentage ownership of the company. Of course, the value of the company has declined by the amount of cash used to repurchase the shares.
A buyback impacts per share data. Therefore, an immediate benefit to shareholders of a buyback is the reduction in share-count which increases dividend per share assuming there is no reduction in the total amount of cash set aside for dividend distribution. The corresponding benefit to management is an increase in earnings per share; many incentives are based on earnings per share growth data, rather than aggregate earnings growth or return on invested capital metrics.
It is therefore understandable in a world of income starved investors and incentivised corporate managers that buybacks are generally welcomed. Indeed, some commentators have been tempted to add the dividend yield to the percentage of shares bought-back to come up with a dividend plus buyback yield. While this might be appropriate at the individual company level, the extension of this type of analysis to the aggregate market level should be treated with caution. A recent paper by Chris Brightman of Research Affiliates provides a more thorough analysis of the activities of companies buying back their shares in the US.
In particular, he highlights the appearance of some of the largest repurchasers of stock on the list of largest issuers. Why would a company buy back shares only to reissue? Typically, to fulfil stock compensation plans. In other words, companies may be repurchasing shares in order to give them to management – hence the need to see companies retiring equity rather than holding in treasury for use as compensation plans vest. Brightman correctly observes that it is wrong to only look at the equity component of the balance sheet; an assessment of debt issuance is also important. He notes that total debt issuance by US corporates in 2014 was US$1.2 trillion. How much of this was used to repurchase stock as opposed to funding growth in operations? Brightman points to a study by his colleague Rob Arnott that observes average dilution through aggregate net issuance of equity on the US Equity Market of 1.7% per annum since 1935. This would go a long way to wiping out the yield impact of buybacks.
This analysis backs up the view we, at Cerno Capital, hold on buybacks – they are a tool of the financial engineers at work within companies (and their advisors) and should be analysed on a case by case basis within the context of the whole capital structure of a business. Most crucially, share buybacks cannot directly alter the operating performance of a company; however, financial engineers can use them to alter the distribution of profits from operations and it is the job of the equity analyst to identify whether or not shareholders are being treated appropriately.
For a full analysis of the value created by share buybacks, we recommend the following article from the consultants at McKinsey;