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Buy-back bonanza: magic returns or financial illusion?

Share buy-backs may seem a valid alternative to cash dividends, but they can be a form of financial engineering that masks corporate stagnation and artificially inflates assets

Buy-back bonanza: magic returns or financial illusion?

Share buy-backs may seem a valid alternative to cash dividends, but they can be a form of financial engineering that masks corporate stagnation and artificially inflates assets.

Companies have been devouring their own shares at an alarming rate.

Share buy-backs have usurped dividends as the main way US firms return money to their shareholders, accounting for 60% of cash returns last year.

Even in Europe and Asia, where dividends are revered, buy-backs have become more commonplace.

Last month, British aircraft parts supplier Meggitt said it would buy back more of its shares, a move analysts priced at £300 million.

Meanwhile Paragon, the buy-to-let mortgage lender, announced a £50 million buy-back.

Chinese internet giant Tencent regularly repurchases its stock, while Japan’s Toyota and Mitsubishi are snapping up their own shares at a record rate.

Total announced buy-backs by Japanese companies in the fiscal year-to-date are more than five times the value of that seen in the same period last year, according to John Chatfeild-Roberts (pictured top), chief investment officer at Jupiter Asset Management.

Financial sorcery

At first glance, buy-backs might seem favourable for shareholders.

By reducing the number of shares in issue, they increase the earnings per share (EPS) and support the share price.

However, critics view buy-backs as a form of financial sorcery that artificially inflates equities and prevents companies from real investment.

In recent years, share buy-backs have ‘become a substitute for investing in the business and have led to companies leveraging themselves up’, according to Ian Lance (pictured, manager of RWC Enhanced Income, Income Opportunities and the recently-launched Global Enhanced Dividend fund.

By increasing its net debt to finance buy-backs, a firm benefits by cutting its tax bill. A temporary boost to the share price might also help management achieve their bonuses.

Shareholder losses

However, unlike cash dividends, share buy-backs do not reward all shareholders equally.

They do not enhance shareholder value overall.

Some shareholders sell, often in hindsight, at a price that is low, thereby transferring wealth too cheaply to the company’s owners.

Others do not, remaining part-owner of a business that is then a riskier investment due to its growing indebtedness.

A corporate form of QE

The outcome in the real world diverges from the textbook result, according to Lance, who draws a parallel with the practice of quantitative easing (QE).

‘QE drives down the cost of funding, and traditional economic theory suggests this lower cost of capital should encourage companies to invest,’ said Lance.

‘The reality is different from the theory, however, as most corporate executives now have very short timeframes and focus on earnings per share (EPS) over pretty much every other metric.’

Hence, companies have used the cheaper cost of funding to issue debt, buy back their own stock and produce short-term boosts to EPS.

‘On the other hand, they don’t hire, invest or spend on areas like research and development as these costs lower near-term EPS, but all are needed to produce economic growth,’ said Lance.

‘You end up with a situation in which real wages languish and labour participation remains low, which means demand remains sluggish.

'Companies’ sales, therefore, flatline but heavy use of financial engineering means their EPS still goes up.’

Good and bad share buybacks

At IBM, the computer hardware company, sales have stagnated and capital expenditure has fallen, but its EPS has risen.

‘It is a finite process,’ said Lance. ‘A company cannot gear itself up indefinitely and share buy-backs are less effective at higher share prices.

'This was highlighted in the recent IBM earnings disappointment, which saw its share price fall 10% in a day.’

IBM has spent on share buy-backs not investment

(Source: RWC, Bloomberg)

EPS at the Next level

While IBM represents a bad example of share buy-backs, there is the odd good one.

High street retailer Next has bought back more than half of its shares in issue over the past decade.

Although its sales have only grown at a rate of 4% per year, its EPS has ballooned by four times that.

The difference is that it has continued to invest throughout this period, both by opening new stores and building businesses like Next Directory.

It only buys back shares with surplus cashflow, not borrowings, and it stops buying back shares when its share price strays into expensive territory, choosing to pay special dividends instead, as demonstrated in 2014.

‘This makes a lot of sense,’ said Lance.

David Smith, co-manager of Henderson High Income Trust, agrees. ‘Capital allocation is the most important responsibility of company management,’ he said.

‘A good example of a company that demonstrates good capital allocation is Next.’

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