Analyses and investment views

Why we like share buybacks (sometimes)

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Originally Share buybacks are a common and frequently also the best way to allocate a company’s capital. This method is sometimes criticized, however. Companies buying back large quantities of their own shares are faulted for attempting to conduct financial engineering that benefits only their shareholders instead of investing into growth that would contribute to the prosperity of the overall economy. I disagree with this opinion and I will attempt to explain why.

It is my opinion that the objective of management is not to grow the company in and of itself but to grow its value as calculated on a per-share basis. These are two entirely distinct objectives. In addition, history clearly shows not only that growth of a company does not automatically mean growth in its value, but also that efforts to achieve precipitous growth, whether organically or through acquisitions, frequently have destructive effects on company value.

A company’s management has six basic ways to allocate its capital. First, it can invest capital within the company. In this case, there are three alternatives: investing into productive capital goods (like technology, plant and equipment), into operating capital, or into mergers and acquisitions. There are three additional options for deploying capital that are outside the company: paying out dividends, buying back shares, and paying down debt.

Management should at all times consider all of these possibilities and allocate capital wherever it brings the highest return. (Debt repayment is a special category. From a purely financial perspective, debt repayment mostly has low return, but its accompanying risk reduction is also an important objective.)

In most cases, management tends to invest capital within the company. Management’s effort to achieve absolute growth often takes precedence over the creation of shareholder value. Few managements regard ongoing return of capital to the owners as an enduring aspect of their business.

Just how illogical and efficient companies’ allocation of capital can be is demonstrated in the case of dividends. I generally like dividends, because companies that do not pay dividends gradually pile up cash. This puts pressure on management to do something with it. In many cases, this leads to either overpriced acquisitions or bad, megalomaniac investments. Regular payment of dividends diminishes this pressure on management and somewhat reduces the risk of catastrophe. Too often, however, companies take an overly mechanistic approach to establishing their dividend policies. They mostly endeavour to maintain a regularly growing dividend or establish an approximate payout ratio (i.e. the proportion of net income that will go to the dividend). The managements of such companies tend to be perceived in a good light. Investors and analysts like companies with regular and predictable development. But this just gives management an excuse to avoid more rigorous considerations about the amount of the dividend. A proper dividend policy should not be rigid and bound by fixed rules determined in advance. If a company has an attractive investment opportunity, it should not pay any dividend. On the other hand, when it has no attractive opportunities, it should pay a huge dividend. Shareholders certainly could find a better use for that money. The amount of the dividend would not be predictable in that case. Rather, it would fluctuate up and down, but this would be better from the perspective of efficient capital allocation. It would be extraordinarily difficult actually to find such a company.

Imagine you own such a company by yourself. It would make no sense to tie your own hands with a dividend policy that would command you to regularly increase the dividend each year or force you to pay out a fixed percentage of the profit. You would certainly find it better to pursue an approach whereby in the years when your company will have no good investment opportunities you would pay out almost the entire profit in dividends. Letting capital lay fallow is a waste of resources. On the other hand, in years when your company has excellent investment opportunities open to it, you will not let them pass you by just because you had decided beforehand to pay a higher dividend. It would be better to pay no dividend and let the company invest the money. Something that looks normal in the world of privately owned companies is altogether exceptional in the world of publicly traded companies.

Share buybacks are very close to dividends. They are in essence the very same thing. The company returns excess capital to shareholders, just in a different form. The advantages are that no tax on dividends must be paid and it gives the shareholders the possibility of choosing how they want to respond. Whereas dividends go to all shareholders whether they want them or not, in the case of share buybacks shareholders can choose whether to hold onto their shares or sell them. Those who want to sell at the supportive price that the company is offering in the market will sell. Those who hold on will see their shares become proportionately more valuable due to the reduced supply of shares, increased earnings per share, and resulting growth in the value per share.

The management should approach the decision on whether or not to buy shares back in the same manner as it does the other options. That is, on the basis of returns on its capital. Pushing up the share price should not be the main objective of a buyback, although managers and investors typically do have that goal in mind. The objective should be to direct capital to where it can earn the highest return. If the return on capital from buying back shares is attractive, then it is a good choice to do so. If doing so is not attractive, then, again, it would be a waste of precious funds to buy back shares.

A decisive parameter is, of course, the price at which the shares can be bought back. A share buyback is essentially nothing else than the company’s investing into itself. Therefore, its expected return must be considered, and that is a function of the company’s value and its share price. The resulting expected return is then compared with expected returns from other options for utilising capital, and if it is higher, then a share buyback should be initiated. The management should therefore be aggressive with share buybacks when share prices are low and very cautious about them when share prices are high. In practice, the exact opposite frequently occurs.

A golden rule for share buybacks could be as follows:

“A company should buy back its own shares if their price is substantially lower than their value, and if the company has no more-attractive investment opportunities.”

The management of every company has two basic roles: to run the company and to allocate the capital that it earns. The first task is obvious, but the second one is frequently overlooked by both investors and managements. Managements generally tend to be better at managing companies than allocating capital. These are two completely distinct functions and require different skill sets. A large part of top corporate managers reached their lofty positions by working their way up from lower positions or by specialising in specific fields. Therefore, these people tend to be experts in the fields within which the company does business rather than in capital allocation. It is very typical, therefore, to see managements that run companies well but allocate capital poorly.

If we at Vltava Fund regard ourselves as long-term investors with an investment horizon measured in years, then it is obvious that efficient capital allocation is crucially important for the development of company value. The longer the investment horizon, the greater is the role played by capital allocation efficiency. A company management that is in its position for a long time frequently makes decisions on allocating capital the collective amount of which exceeds the company’s market capitalization. This provides great potential for both creating and destroying value.

When we look at US market statistics, we find that companies return more capital to shareholders through share buybacks than by way of dividends. This was not always the case. Share buybacks were relatively rare until the beginning of the 1980s and their volume was only about one-tenth that of dividends. In the 1990s, however, there came a turning point. At the end of the 1990s, buybacks for the first time exceeded dividends, and at the end of the 2018 they were almost 50% greater than dividends.

The total sum of dividends and buybacks for the past 12 months in the US was USD 1,090 billion. Of this amount, buybacks accounted for USD 646 billion and dividends for USD 444 billion. The dividend yield of the index was 1.81%, but if buybacks will be included as well, then the total yield rises to 4.69%. This much money is currently flowing from companies to their shareholders. By the way, this sum is larger than what was the market capitalization of the entire market 40 years ago.

Under certain conditions, share buybacks are beneficial for the economy as a whole, too. If a company does not have sufficiently attractive investment opportunities and buying back shares appears to be the best use of its capital, then the flows of cash do not end there. The money comes into the hands of shareholders who can put it back into the economy by spending it on consumption or by investing it into more attractive investment opportunities. Eventually, that money finds its way to where it will be used more efficiently than if it had remained held by the original owner. Share buybacks also provide much greater flexibility than, for example, dividends, and they allow management to respond more quickly to the dynamic development in business and markets.

Share buybacks need to be accounted for, and they play a big role in analysing a company. Approximately three quarters of Vltava Fund portfolio consists of shares in companies where share buybacks play – and will continue to play – an important role in creating value. In all cases, these are companies that are in the stable phase of their life cycles. Investors frequently consider this stage to be boring and unattractive. In fact, however, an accompanying phenomenon of such companies is their rather smaller need for capital investments into growth – and therefore high free cash flow. If this free cash flow can be returned to shareholders through share buybacks for attractive prices, then the growth in the company’s per-share value not only can be surprisingly large, it may also be accompanied by an absence of the high risk that is typical for rapidly growing companies.

The influence of a share buyback on company value can be expressed by the equation shown in Figure 1. Figure 2 shows a hypothetical example that uses the same formula but puts in actual numbers.

Figure 1:

% growth in value per share=(1-(% of shares bought back × (share price)/(share value) ))/(1-% of shares bought back)

The example in Figure 2 assumes that the directors and management of this hypothetical company decide to buy back 15% of the company’s shares outstanding. The actual value of the company is USD 120 per share, but the company is able to buy back its shares in the market for USD $80. As a result of the company’s buying back its shares at a price lower than their fundamental value, the value of the remaining shares increases by approximately 6%.

Figure 2:

% growth in value per share=((1-(15 %*80/120)))/((1-15 %)) = 5,88 %

We always say that the only logical way to invest is such that the price we pay is lower than the value we get in return. The same holds true for share buybacks. Invest with care!

Daniel Gladiš, 6 December 2018


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