Market Update - The growing popularity of share buybacks

Market Update

The growing popularity of share buybacks

Share buybacks and dividend pay-outs are both ways that a company can return money to its shareholders. This should happen when a business has generated more cash than it can reasonably invest back into the company, or if there are no obvious acquisition targets. Back in the ‘good old days’ when few people held a portfolio of company shares outside of a pension fund, dividends were the main way that shareholders were rewarded for their loyalty. Successful companies put aside a proportion of their profits to pay out a dividend on a regular basis, typically biannually. This encouraged investors to buy and hold shares in the company. An increase in the dividend was obviously positive, while a dividend cut would indicate a company’s lack of confidence in its future performance. Dividend payments could be reinvested in the company’s stock, used to purchase shares in another company, or to buy a yacht. Once you received your dividend cheque, and paid any tax owing, you were free to do what you liked with it.

Popular dividend payers

Some companies were lauded for paying high and regular dividends. This made them very popular with both small investors and large funds alike. Lloyds Banking Group was a perfect example. At the turn of the century Lloyds would regularly pay out dividends of over 30 pence per share each year, making it a favourite amongst the boring old value stocks. But that came so a sudden halt as the financial crisis hit in 2008. It took the bank seven years before it was profitable enough to restart dividend payments which recently amounted to just 1.24 pence per share, a long way short of its glory years.

Buyback advantages

In contrast to dividend payments, which adhere to a strict timetable, a company can announce a share buyback at any time. The company will spend money, sometimes borrowed, to buy back its own shares. This reduces the number of shares in circulation which instantly increases the earnings per share ratio, making the stock more attractive, and boosting the value of existing shares. This is good news for shareholders, and great news for those company executives who have bonuses and option schemes linked to share price performance. Buybacks are more flexible than dividends when it comes to getting money to shareholders. Buybacks have no specified timeframe, so they can be slowed down if market conditions deteriorate. Also, buybacks are subject to capital gains tax which is only payable once an investor sells their shares. With dividends, investors must pay income taxes once the dividend is received. A dividend-paying company doesn’t have to pay a dividend. But if an organisation decides not to, or even reduces its dividend, then this reflects badly on the company. It’s common for the shares to get sold off sharply by investors. In contrast, the initial announcement of a buyback is viewed as an unexpected bonus.

 

 

Borrowing to buy back stock

But there are concerns around buybacks, and some observers aren’t happy that they are favoured by many executives over dividends. Stock buybacks don’t contribute to a firm’s productivity. This is particularly the case when a company borrows to fund the buyback rather than using cash earned on its activities. It’s true that until relatively recently borrowing costs were lower than they had ever been, so it made sense to borrow money to invest in new plant and machinery or R&D, which can all contribute to future sales and profitability. But taking on debt to fund buybacks doesn’t generate additional revenue, while interest on the debt is a liability on the balance sheet.

Other concerns

Even when a buyback is paid for out of cash there’s often a question mark over why executives choose to take this route. Spare cash could go into corporate expansion, staff training, new equipment, paying down debt or acquiring a competitor. Some have argued that if the corporate executives really can’t find a way to reinvest spare money into the business, then maybe they should be replaced. After all, the company must be successful to make the cash in the first place, so using that money to expand the business would make sense. There have been suggestions that executives choose stock buybacks as so much of their compensation is linked to a higher share price. In addition, any increase in the share price following the announcement of a buyback tends to benefit short-term speculators rather than those investors looking for longer-term value. The boost in the stock’s price sends a false signal that the company is thriving. But this is simply due to financial engineering rather than organic growth.

Buyback supporters

The counterargument is that investors like stock buybacks, and that boosting shareholder value is the responsible thing for executives to do. After all, not all reinvestment is a good thing as poor management can lead to poor investment decisions. Consequently, returning money to loyal stockholders can be the right thing to do. But many believe that raising the dividend is the best way to do this. Firstly, it rewards long-term investors in a way that buybacks don’t. It also gives them a cheque which they can spend how they like. On the flip side, shareholders have no choice over when a dividend is paid and must pay ordinary income tax on them. With a buyback, investors can choose when they sell their shares, and it is only then that they pay tax at a capital gains tax rate which declines once the stock has been held for more than a year. Many investors prefer this arrangement.

Pandemic effect

For obvious reasons, share buybacks fell in popularity as the pandemic hit. Some companies made the decision to halt share repurchases, but others had no choice. The US Federal Reserve barred major US financial institutions from both buybacks and dividend pay-outs – a restriction which has since been lifted. Buybacks have increased and are now back to pre-pandemic levels. It has been the US tech giants which dominate when it comes to buybacks. According to analysis by Standard & Poor’s the tech sector accounted for $56.4 billion of buybacks, representing 36.1% of all stock repurchases in the first quarter of 2021. Apple topped this list, buying back $18.8 billion of stock alone in the first three months of 2021. Recently Apple and Alphabet said they would return $90 billion and $50 billion to their shareholders, respectively. Then Microsoft said it would buy back $60 billion-worth of its shares, its biggest ever offer, with no end date and the option to terminate at any time. Microsoft’s news came soon after two Democrat senators announced that they were pushing for additional tax on buybacks while launching a ‘Stock Buyback Accountability Act’ which is designed to help workers rather than enriching stockholders. Ultimately, while buybacks typically give a company’s shares a short-term boost, long-term value comes from a company’s financial stability, along with its ability to achieve growth and make money. Discovering which businesses are good at this while their shares are reasonably priced is the secret sauce for successful investing.