By Alasdair Birch
STRANGE things have been happening in financial markets. You might think I am talking about Nvidia reaching $3 trillion dollars in market value. Or that a multi-billion Singapore-domiciled but China-based fast fashion retailer could IPO on the London market. In fact, there is something else much more exciting. Many companies are buying back shares …
Hang on. Buybacks, exciting? Don’t buybacks happen in the US when markets peak and companies spend lots of money at exactly the wrong time? Or when management teams underinvest and try to boost their earnings per share so they get paid more? In the past, yes, that was often the case. And for many, recent history shapes reputation – share buybacks are bad and best avoided.
But while large US technology companies have long dominated the share buyback rankings, the practice has quietly become more widespread. Companies in Japan, the UK, even conservative family-owned companies in Europe are all using buybacks.
What is also unusual are the wider circumstances. Outside of the technology sector we are not in the typical environment of exuberance. There are hardly any IPOs. Interest rates have remained high so using debt is restrictive. Economic growth is hanging in there, but apart from India, not much to write home about.
Companies are not taking on debt, nor are they cutting back on capex, dividends, or M&A. The opposite is generally the case. Much-needed replacement that was postponed during Covid is now happening. Decarbonisation projects can be expensive and cost inflation is a major challenge to previously set budgets. Why, then, are we seeing share buyback newcomers?
It is worth revisiting what the point of share buybacks is. The theory is simple. After all the cash adjustments have been made to reported earnings due to differences in timing, and any reinvestment has been paid for, a company’s directors can then choose whether to make acquisitions, pay down debt, increase the cash balance or return the money to shareholders. Returns can come in different forms of dividends and/or buybacks.
While shareholders might think they would be indifferent, taxation aside, there are some important distinctions. Regular dividends have become an established signal of management confidence and business quality. The tradition is for them to be increased over time, and unexpectedly cutting a dividend is a surefire route to unpopularity.
Buybacks have a wider range of outcomes. When companies perform buybacks, they are effectively buying out the most price sensitive (or least optimistic) of the existing shareholders, swapping cash today for increased ownership on behalf of the remaining shareholders.
Many companies use share buybacks to distribute windfall gains, neutralise share-based compensation or as a release valve for large-scale cash build-up. These typically include large dominant franchises with high margins. The largest buyers of their own shares in the S&P 500, with more than $1 trillion spent over the past decade, have been the likes of Apple, Alphabet, Microsoft, Meta and Wells Fargo.
The danger with buybacks comes when the valuation of the shares is high, or when they are funded by expensive debt. The buyback is then swapping a certain value or obligation, for a potentially overpriced asset in shares, and can leave a company in a weak financial position. There are many case studies of what can go wrong: GE, Boeing and Hewlett Packard among them.
When I speak to some recent buyback newcomers, however, a different picture emerges. These companies are typically market leaders in boring business-to-business niches such as specialty chemicals or cement and aggregates, and have worked hard to attain strong balance sheets. They pay growing dividends and are reinvesting cash flows.
But they have a common complaint – they are not American technology companies. And, as such, they feel their share prices have been left in the bargain bin.
If you have the patience to be one of the remaining shareholders, these situations are part of the beauty of equity investing. Companies can choose to increase your proportional ownership, at cheap prices, with no decision or extra money from you required. Even better, when share prices go down you can, in fact, celebrate – your bargain just got an extra discount and your future returns have gone up.
Some of my colleagues have always wondered why I am so happy when markets are in the red. Now they know!
Alasdair Birch is co-manager of WS Saracen Global Income & Growth
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