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I received a letter from a piqued reader this week condemning share buybacks as a ‘scandalous waste of money’ that ‘mostly don’t work’. It was a bit of a rant to tell the truth, albeit, not necessarily a misplaced
one, but I’d not given much consideration to the subject lately, and thought I better had.
Share buybacks have been booming. Vodafone, Shell and BP are just a few of the UK’s bigger and better-known companies at it, Tesco and AstraZeneca too. Telecoms firm BT is currently part way through a £2.5 billion buyback programme – worth over twice last year’s dividend payout – and virtually every one of its last dozen or so stock exchange announcements have been to this effect.
Now we know that share buybacks make sense, right? They’re a tax efficient way of returning cash to shareholders, even if you’ll never see a cheque, because they boost the proportion of earnings attributable to each individual share. In other words, earnings per share rises, which should underpin a subsequent rise in the share price.
However, research was published last year by Morgan Stanley that paints a different picture. It shows that the share prices of companies running share buyback schemes lag the rest of the market, with shares in buyback firms rising an average 8.2% a year compared to a 10.3% average return for the market as a whole, and 12.7% for firms that boosted their dividends instead.
And that’s not all. There’s a potential double whammy when buying back shares when the market is falling, since as cheap as management may believe its stock to be at a given moment, during a bear phase, there is always a good chance that the shares will be even cheaper a week or two later. As our reader reminds me, nightclubs-owner Luminar spent a considerable sum on buybacks when the stock was at 800p or so, yet today the share price is worth less than half that, at about 340p.
While this all seems to add up to a full condemnation of share buybacks there are a couple of points I believe are worth making. Firstly, share buybacks can act as a signal of a management’s confidence, allowing them to flag up to the market a strong belief that its shares are undervalued. In fact, there is academic research that shows that the best performing share buybacks come from companies in which management are not among the selling shareholders. Second, buybacks can actually provide a useful way to re-jig a company’s capital structure by reducing expensive equity in exchange for cheaper debt financing. Also, buybacks can provide useful flexibility as a company’s circumstances change – the market is far less likely to mark down a company’s share price on news of a halt to a share buyback programme in the way it would on news of a cut to the dividend.
Of course, for buybacks to be effective they do need to be handled tactically. It’s no use buying shares in the market willy nilly, it’s only useful when the share price is genuinely in the doldrums, yet this means trusting a firm’s management, or its broker, to gauge the shares’ true worth accurately, always a difficult task, as readers will know. Still, that buybacks may not always work as they should does not necessarily mean that the logic behind them is complete hogwash. But perhaps the best solution would be to see more one-off, special payouts made by companies. This would be a very tangible way of returning surplus cash to shareholders, who at the same time could choose to re-invest the bonus cash back into the shares should they wish to remain exposed to the underlying investment potential of the company. Even though investors would have to pay tax on the income, it sounds like an ideal compromise to me.
Sizing up the big numbers
I’m not going to bang on about the latest financial scandal that saw Jerome Kerviel, a 31-year old futures trader at Soc Gen, run up losses worth over $7 billion. That’s nearly four times the deficit accumulated by Britain’s own ‘rogue trader’ Nick Leeson, by the way, who led Barings to the brink of collapse with debts worth £800 million.
What I want to know is, despite regularly encountering such vast sums when you work in the financial world, how much exactly is $7 billion? I’ve been reading one of Bill Bryson’s excellent books lately and he has an eye-opening way of explaining similarly mind-boggling sums, so I’m going to shamelessly borrow it here.
Imagine that $7 billion was stored in single dollar bills within a great big warehouse, and you were generously offered the chance to take as much of that loot as you could initial. Now let’s say, for arguments sake, that you could initial a one dollar note every second. How long do you think it would take to scribble your way to a $7 billion fortune? A week, a month, five years?
If you initialled one dollar a second you would make $1,000 every 17 minutes, and after non-stop effort, you’d make your first million in about 12 days. Therefore, it would take you 120 days to make $10 million, and 1,200 days – a bit more than three years – to secure $100 million. Given close on 63 years, of solid effort mind, you’d be worth roughly as much as Sports Direct’s Mike Ashley, yet you’d still be little more than quarter of the way towards the near 222 years it would take to initial $7 billion. I don’t know about you but this seems staggering to me, and the next time I write figures of this magnitude, I’m going to have to pause and think about it for a moment. In fact, I have to stop writing now, my head is starting to hurt.