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Boardroom benevolence?

08 May 2015

Nick Purves of RWC Partners explores the reasons behind the rise in company share buybacks and what it means for investors.

US companies are forecast to buy back over $1 trillion of their own shares in 2015. Apple spent a staggering $17 billion on its own stock in the fourth quarter of 2014 alone. Here in the UK, the figures are smaller but no less exceptional when compared with history. So why do companies buy back their own shares, why are so many companies doing it right now, does it create value for their shareholders and does it tell us anything about the wider economic environment?

Starting with the question of why a company would buy back its own shares, one of the key duties of company management is to allocate capital sensibly on behalf of the shareholders of the business. Their options are debt repayment, expansionary capital expenditure (either organic or through acquisitions) and returning excess cash to shareholders via ordinary dividends, special dividends or share buybacks.

If a company that makes £1 million in profit has 10 million shares in issue, then earnings per share (EPS) will be 10p; but by repurchasing and cancelling 1 million shares, then the EPS, all other things being equal, will rise to 11.1p. There are, however, other considerations as the company may need to borrow some money in order to buy back its own shares. In essence, the company is swapping equity for debt and hence the impact of the process depends on the relative cost of the two.

This helps answer the second question; why so many companies are buying back their own shares right now. As quantitative easing drove down the cost of corporate debt, so the impact of buybacks on EPS has increased, which has made it a more attractive option for companies. In addition, a new breed of activist investors is pushing companies to return any ‘excess cash’ to shareholders.

Adding value?

But does this increase in earnings per share actually add value for the shareholder? The answer here is ‘only up to a point’ and, indeed, if the return on the buyback is below the cost of raising the capital, it is possible the process enhances earnings but reduces value. Many will say that the value of a firm is derived from its future cash flows and that transferring cash to shareholders via a dividend or share buyback does not change this value. In reality, as the interest payment on debt is tax deductible, swapping some equity for debt can help lower a company’s financing costs; but as the debt load on the business increases, lenders will become more wary and the cost of borrowing will increase. The owners of equity will also become more concerned since they sit below the debt holders in the capital structure of the business.

Corporate confidence

Finally, does this trend towards buybacks tell us anything? As buying back shares has a guaranteed initial benefit, versus one which may have a larger but more uncertain payoff in the future (such as building a new factory), this may suggest that company CEOs are becoming more short term in their outlook. Executives are increasingly remunerated with stock and yet on average have a short life expectancy in the top job; hence they may favour schemes likely to boost their share price in the short term. In addition, it may tell us that CEOs do not trust the economic recovery as QE has lowered the cost of financing but it hasn’t really benefited their end customers and produced an increase in demand. A share buyback is easier to cancel in the event of a downturn than a major investment project.

Lessons from the past

As most company executives are much less able to predict the future than they would have you believe, share buybacks tend to mirror the stock market cycle; levels peak at the top of the market and vice versa. In addition, increasing leverage increases a company’s risk. In the two years before Lehman went bust, American financial services companies repurchased $207 billion of shares – only for taxpayers to have to inject $250 billion in to many of the same companies in 2009 to rescue them. 1

Nigel Wilson, CEO of Legal & General, believes the tendency to favour debt over equity is a problem for the wider economy. “The world is over-leveraged… We desperately need to revive our equity culture to help entrepreneurs build businesses, boost future growth and widen the benefits of ownership.”

We would agree with him; loading companies with debt may result in short-term returns but this is often at the expense of longer-term wealth creation, which cannot be good for shareholders or the wider economy.

The opinions expressed are those of Nick Purves and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or St. James’s Place Wealth Management.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

1 ‘The repurchase revolution’, The Economist, 13 September 2014

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