There is a certain undeserved mysticism to the share buyback.
There are few greater alleged accolades than for an overview of a business to conclude with “… and they’re buying back their shares”. Therein lies an implication of double praise: not only is the company generating excess cash by the bucketload, but management is so laudably prudent and shareholder-friendly that it will not waste the hard-earned readies on frivolity. Management is savvy, a team to be trusted; chaps you would invite to the golf club.
At the end of each year every company asks itself the same questions: have we made any money and, if so, what do we do with it? This ought not to be too vexatious, there being only a very limited number of options for consideration. The company can hoard its cash in the bank, it can invest it in some shape or form, it can pay dividends, or it can buy its own shares. It is not a long menu for consideration; it’s the pre-theatre prix fixé, not the à la carte. But it is astonishing how many boards get it totally wrong.
The rationale for the buyback is simple: if a company reduces the number of shares in issue, then you the shareholder necessarily own a greater proportion of the remaining equity. QED, the buyback must be a good thing.
But there is a teeny-weeny flaw in this one-size-fits-all theory: there is nothing causal in the relationship between buybacks and the creation of value. Buying back shares that are expensive is tantamount to the wanton destruction of shareholder value.
To illustrate this, let us briefly dive into investment trusts. It is now common for investment trusts to buy back shares when they trade at specified discounts to net asset values. This makes obvious sense: the trust is buying cheap assets for the benefit of shareholders. For example, as a result of its current discount, Standard Life UK Smaller Companies Trust has announced a tender offer for up to 5 per cent of its shares and has stated it will buy back more shares at discounts of more than 10 per cent as and when this is possible.
Contrast this approach with that of Royal Dutch Shell. In an outstanding example of a board appearing not to understand GCSE corporate finance, Shell has committed to spending at least $25bn (£16.3bn) buying its own shares between 2017 and 2020, at unknown prices. Its board has no way of knowing if this will be good or bad for shareholders. Rather, it seems to be is lip service to the erroneous mantra that buybacks are always a good thing.
Instead, buybacks are all too often only a good thing for executive remuneration. Buybacks raise earnings per share – a key metric for incentive-based pay – even if overall earnings are lacklustre. Cash that could otherwise have been used to invest in and grow the business is instead used to financially engineer short-term targets, regardless of the impact on long-term shareholder value.
Buybacks are like pufferfish – wonderful in the hands of experts, but likely to be toxic when not.
Jim Wood-Smith is head of research at Hawksmoor Investment Management
