James Harries, global income fund manager at Troy Asset Management, discusses his thoughts on share buybacks.
Excess cash and cheap debt have helped fuel share buybacks
Low interest rates have encouraged share buybacks on two fronts. Not only have companies enjoyed historically cheap rates of borrowing to keep funding healthy, but the low rate offered on savings also means pressure builds quickly on companies sitting on idle cash.
Interest rates have started to rise in both the UK and the US, and the
Bank of England (BoE) and the
Federal Reserve (Fed) are both expected to continue raising rates this year, and possibly beyond. One concern is that some companies use cheap debt rather than their own cash flow to fund their share buybacks and, while rates are to rise going forward, it is unlikely to be enough to discourage firms from spraying investors with cash.
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Monetary policy is continuing to be geared toward supporting economic growth and propping-up inflation, and corporate debt levels are expected to continue rising from recent record-highs. The ability to borrow even when cash flow is deeply in the red is demonstrated by the likes of Tesla, which is racing to become self-sustainable before it runs out of money later this year.
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crunchtime for Tesla
Do share buybacks prioritise short-term profits over long-term investment?
‘Corporate profits and cash reserves are at an all-time high. However, many companies have been spending an increasing share of profits and cash on buying back their own shares while the share of profit spent on investment in equipment and structures is often falling,’ – Deloitte, November 2017.
At the centre of the case against share buybacks is the argument that companies are prioritising short-term profits and returns to shareholders over vital long-term investment. This chart represents the net difference spent by US firms on buybacks and on net capital formation, referring to the additions of capital stock, like equipment and tools.
Meanwhile, the amount being invested by companies recovered at a much slower rate after the crisis, and global capital expenditure only managed to buck a trend of tighter spending last year following four years of annual declines, according to S&P Global.
There are some theories that could partly explain any perceived correlation between the amount being invested by companies and the amount returned to investors, particularly through buybacks.
Has technology changed the investment needs of businesses?
One possible explanation is the impact of technology and its rapid development. Investment, led by high-valued tech firms, is being channelled more into the likes of software and intellectual property rather than more traditional investment in the likes of property or equipment. Investing in tech also helps to drive everything else, from productivity to efficiency, which at the bottom-line, all allows profit and cash flow to thrive.
Against that backdrop, it is worth noting that the companies spending the most on research and development (R&D), rather than capex, are returning plenty of cash to investors. The outlier, however, is the company that spends the most on R&D in the world, Amazon, spending over $16 billion annually. Jeff Bezos, firmly in control of his company, has avoided the need for share buybacks and has shunned dividends to prioritise the heavy investment in growth that has fuelled the rise in share price, which so far has kept shareholders interested.
The second biggest spender, Alphabet, has not paid a dividend but has repurchased shares which in turn has supported its share price. The other biggest R&D spenders, including Intel, Samsung, Volkswagen, Microsoft and Apple, flex both arms by paying dividends and repurchasing shares.
Apple $100 billion buyback: generating more money than it can spend
Apple is a good example of a company that seems to be generating more cash than it knows what to do with. The iPhone maker has grown dividend payments over the years and started making returns in 2012. By the end of March this year, Apple shareholders had been paid a whopping $275 billion-$300 billion of which was returned through share buybacks.
Apple has now conducted six of the top ten largest quarterly share buybacks on the US stock market and, not to stop there, has revealed it will buy another $100 billion worth of stock going forward. It is hard to argue against Apple’s choice to return the cash – it had $145 billion in the bank at the end of March.
US Tax reform and infrastructure plans: where’s the money going?
US President Donald Trump fought hard for his tax reforms, which include a cut to the corporate tax rate to 21% from 35%, and the overhaul was seen as his first major legislative success since taking office. This should encourage US firms that have been hoarding their cash in offshore accounts in order to avoid high taxes to repatriate funds back home.
That, coupled with Trump’s $200 billion infrastructure investment plan, sounds like the ingredients needed to get companies investing in America again. However, many fear that this has only opened the doors for a flood of more cash to flow to investors and prompted the question: where will the money freed up from tax cuts actually going to go?
Read more about how the US tax reforms will impact US stocks and the dollar
Apple may have announced the largest buyback since the tax reform was passed in December, but it is not the only US firm to reward investors, with hundreds of companies unveiling buybacks worth over $285 billion. As well as Apple, that sum includes Cisco Systems’s $25 billion buyback, Boeing’s $18 billion return and the $12 billion buybacks launched by both Oracle and Broadcom.
The Institute for New Economic Thinking is convinced tax cuts in the US will only fuel buybacks.
‘The deceptively named Tax Cut and Jobs Act slashes the corporate tax rate from 35% to 21% on the theory that companies will use the extra after-tax profits to make productive investments that will create jobs for Americans. Yet it is clear that instead of helping to rebuild the vanishing middle class, corporate executives will funnel the tax savings to already-rich shareholders through stock buybacks and cash dividends, increasing their take from the stock market. As a result, the nation’s rampantly unequal income distribution will only become worse,’ the think-tank said.
Globalisation’s impact on investment
Another theory explaining the changes in how companies deploy and invest their money is the impact of globalisation. As countries and companies develop, they increasingly shift work such as research or manufacturing to other countries. This channels the budget abroad and lowers the cost of investment, while boosting profitability and therefore the amount of cash the company has.
The open nature of global markets has indeed lowered the need for investment. For example, big tech and data firms in the US currently take data from the European Union (EU) and process it in the US. However, the introduction of General Data Protection Regulation (GDPR) threatens their access to data in the EU and firms like Alphabet have warned, in a worst case scenario, it may have to duplicate its operation in the EU as a result – incurring a huge amount of investment.
Learn more about the effect of GDPR and how big tech is responding
Business needs both confidence and encouragement to invest their funds. The monetary policy has so far been favourable, but the uncertainty spawning from the likes of Brexit and Trump’s more nationalistic view can deter companies from investing for the long term until the picture becomes clearer, forcing them to take a shorter-term view.
Why do companies choose to return cash through share buybacks?
If the company is sufficiently investing and addressing any debt on the balance sheet then it is hard to justify anything else apart from returning this cash to investors. But why do companies favour share buybacks rather than just raising the dividend?
There are a couple of reasons. Firstly, some investors prefer share buybacks because they are subject to capital gains tax, whereas dividends fall under income tax. Secondly, a company that introduces a dividend often aims to progressively grow the payout as the business grows. Share buybacks on the other hand, are more flexible as boards secure the authority to repurchase shares in advance, with the ceiling dictated by either a monetary value or by a set volume of shares. Buybacks are often one of the first expenses to be cut when times get tough, and businesses are far more protective of their dividend.
Companies also operate buybacks to offset the dilution that comes from issuing stock options to staff or board members. Apple has previously said repurchasing shares helps swallow the amount of new stock issued to staff, and oil giant BP recommenced its share buyback last year to offset the dilution coming from its scrip dividend.
The pros of share buybacks:
- Let’s investors decide: returning cash to investors can allow them to deploy the money where they see fit, possibly reinvesting in other stocks or financial instruments
- Could signal shares are undervalued: companies should look to buy shares when they are undervalued, so an announcement of a buyback could be a sign that management believes shares are undervalued
- Supports share price: this in turn helps to support the share price as it not only decreases the amount of shares in issue, but attracts interest in shares if sentiment believes shares are undervalued
- Increased dividend: investors that choose not to sell shares when company look to repurchase their stock can expect a better slice of future dividend payments as the share capital will have decreased after a buyback
- Tax benefits: some investors prefer share buybacks over dividends because they are subject to different forms of tax, with buybacks falling under capital gains and dividends under income tax
- Better than sitting on idle cash: companies are increasingly discouraged from sitting on large piles of idle cash
The cons of share buybacks:
- Buying high: one of the biggest criticism of buybacks is that companies are often repurchasing stock when it priced high, rather than repurchasing shares when they are undervalued. Companies tend to have plenty of spare cash when business is good and shares are overvalued.
- Massages earnings per share (EPS): EPS is directly massaged by the effect share buybacks have on its issued share capital, which can suggest a company’s profitability is improving at a better rate than it actually is
- Exec pay: the growing link between the targets set for executives to achieve in order to secure their stock bonuses and the likes of EPS, price to earnings (P/E) ratio and share prices mean management have reason to favour share buybacks for their own gain
- Buybacks and debt: concerns are growing that many buybacks are being supported by the floods of cheap debt available to companies rather than its own cash flow, casting doubt over the sustainability and justification behind some share repurchases
- Short-term returns over long-term investment: those critical of share buybacks argue that companies are not spending enough on long-term investment in order to dish out short-term rewards to investors
Why are companies pressured to return cash to investors?
Share buybacks obviously serve the primary goal of returning cash to shareholders, but pressure to do so goes beyond simply burning a hole in a company’s pocket.
M&A can be a big driver behind share buybacks, which help provide a bonus by distributing the proceeds from selling off a business or returning the savings yielded from a deal. Pharmaceutical firm Shire sold off its Oncology division for $2.4 billion, and has pledged to return those proceeds by repurchasing its shares, depending on how the £46 billion takeover by Takeda Pharmaceuticals pans out after being agreed earlier this week.
Equally, the London Stock Exchange (LSE) announced a buyback as compensation for the failing to complete a tie-up with German counterpart Deutsche Boerse (and not for the first time). The LSE said it would repurchase £200 million worth of shares, ‘broadly equivalent to the return we would have made had the merger with Deutsche Boerse proceeded as planned’.
Activism is also playing its part. Activist investors are increasingly hunting for businesses that are being mismanaged or that they can break up. They aim to invest, apply pressure on the board to make changes, and reap the benefits of building a better business. Whitbread has recently succumbed to pressure to split off Costa Coffee from Premier Inn over the next two years in what should yield over £3 billion of value, according to prominent activist Elliot Advisers.
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activist investors and how they work
While some activists push for higher returns, Elliot is not looking to spin-off Costa, take out all the cash from the business and give it to shareholders. However, this still demonstrates another reason why companies feel the need to sweeten investors and win their support through buybacks. Some use it as a method to stave off any prying activist eyes, or any unwanted attention from peers that are eyeing the business as a takeover target.
Read more about activist investors and how to use them in your trading strategy
There is also the longer-term trend that has seen management shift their business models to one that puts shareholders first (remembering that executives are shareholders themselves, more often than not). Growing shareholder returns or shareholder value are now a priority for many companies and the argument is that this is a major driver for the short-term focus over long-term investment.
A lack of trust means investors can pressure companies to return cash
One of the arguments in support of the view that companies are focusing on short-term returns rather than making the necessary long-term investments is the lack of trust in stock markets and the growing disconnect between the financial system and the general public. Tying into the rise in shareholder activism, boards and their strategies are coming under more scrutiny than ever, and if investors don’t trust the management to effectively deploy the company’s cash then they will be keen to encourage the company to return cash to them.
While returning cash to shareholders does take money out of the business, it does allow investors to take that money and deploy in whatever way they see fit, possibly reinvesting in other stocks or financial instruments. If the cash being returned through buybacks is being reinvested into financial markets then buybacks can provide liquidity and allow investors to shift money into better investments.
There is also a peer pressure effect. Many companies that don’t offer dividends or buybacks manage to drive their share prices by delivering impressive growth, but as share buybacks help support share prices and can provide a boost to EPS figures, companies can be enticed to conduct buybacks in order not to get left behind the wider market.
If the company has no debt worries and a surplus leftover after outlining its budget then it can be very hard to justify sitting on cash without a cause, especially if the outlook for the business is rosy and there isn’t a need for some form of safety buffer.
The link between executive pay and share buybacks
The investors that are cautious about entrusting management to deploy cash in the long term and wary of share buybacks do have good reason.
A company’s issued share capital declines when a company repurchases its own shares and as a result, the company’s per share metrics, particularly EPS, then rises because its earnings are divided over a smaller share structure. While there is a concern on how share buybacks massage EPS and muddy the progress a company is making, there are bigger questions being asked between the relationship of EPS and executive pay. Executive pay as a whole has been under attack over recent years, particularly as more attention is paid to the likes of gender pay gaps and the difference between the pay of a standard worker and a company’s chief executive.
But how do share buybacks fit in? Remuneration packages often include stock options that are awarded to executives when they achieve certain targets, and one metric that is commonly used is EPS. This therefore gives management a reason to focus on raising EPS to hit their goals, rather than focus on improving the actual profitability of a company, and one way to do this is through a buyback.
The scale of this potential problem seems relatively small at present but substantial enough that the UK government launched an investigation looking at whether some companies are ‘repurchasing their own shares to artificially inflate executive pay’. The investigation will look to address concerns that ‘executive pay can sometimes be disconnected from company performance’.
Board members are increasingly expected to take shares in the company they manage, to ensure their interests are aligned with other shareholders and to give them more of a stake in the business, which should create greater accountability and motivation to make the company succeed. However, how remuneration packages are shaped means it is fair to ask whether pay packets currently make boards more invested and accountable, or actually makes them more self-interested.
Alex Edmans, a professor at the London Business School that is assisting the government with its look into buybacks, said a wide net needs to be cast to ensure the investigation does not focus on ‘one or two high-profile anecdotes’.
‘The deeper problem may be the focus on short-term earnings, which induces not only buybacks but also investment cuts. Treating the underlying problem may be more effective than treating the symptoms,’ the professor said in January.
‘While some buybacks may crowd out other investment or be used to inflate executive pay, others can be good for society and not just shareholders,’ Edmans added.
US stocks tend to return more cash by buying its own shares, and buybacks led by the pharmaceutical and technology sectors have helped support US markets climb to record highs since 2009. Still, many UK companies continue to repurchase their own shares. Interestingly, UK firms returned £15 billion in the 12 months to January 2018, according to Goldman Sachs, but issued £17 billion worth of new equity.
HSBC, Lloyds Banking Group and Rio Tinto are some of the largest companies to have announced new buybacks this year, while the likes of Domino's Pizza Group, Burberry, Pearson and RPC Group all continuing to buyback shares this year under programmes launched in 2017.
Conclusion: focus on the impact of a share buyback rather than the buyback itself
‘Buybacks of common stocks will account for the largest share of US equity demand during 2018. It is powered by an extraordinarily high ratio of cash to assets on the part of the Standard & Poor's 500,’ – Forbes.
There are few signs that the rate being returned through share buybacks will slow anytime soon, and therefore the debate over their impact will only grow. The chief executive of Airbnb, Brian Chesky, told the Financial Times (FT) earlier this year that he was unlikely to take his company public this year because of the pressure a public shareholder base brings.
‘It’s because companies try to act in the interest of their shareholders that the public is distrusting of large institutions and corporations,’ he told the FT.
The shareholder-first model has had a significant effect on the level of trust between the public, investors and companies. Share buybacks may well be just one part of a much wider cultural problem within markets.
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But the general attitude toward share buybacks should not be negative. Justifying a buyback all depends on a company’s individual circumstances, that factors in everything from investment needs, debt, cash flow generation and any external pressure they are dealing with. Investors should focus not on the size or value of the buybacks announced but ask what the impact of that buyback is on the rest of the business. Have new projects or investments been starved of capital because of the buyback? Could the funds be used better to address any debt? Is there any concerns over the future of the company that could require a buffer in the bank rather than spraying shareholders with cash?
The important point is the impact of a share buyback on the other parts of the business rather than the effect of a buyback on its own.
If there is no better use for the cash then investors should cheer the money being thrown at them. A share buyback should demonstrate strong cash flow and as the amount of cash generated continues to rise, then the more money companies will have and be expected to return to shareholders.
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