To an income oriented investor, today’s low interest<br /> rates are proving to be a challenge. The “easy money” policies of most<br /> central banks have driven interest rates “lower for longer” and created<br /> a demand for income oriented equities. The boards of many publicly<br /> traded companies have responded to the demand by promising to return<br /> cash back to shareholders through increased dividends and stock<br /> buybacks.
The following Pacifica Partners article was also published in the Financial Post
To an income oriented investor, today’s low interest rates are proving to be a challenge. The “easy money” policies of most central banks have driven interest rates “lower for longer” and created a demand for income oriented equities. The boards of many publicly traded companies have responded to the demand by promising to return cash back to shareholders through increased dividends and stock buybacks.
While dividends are the most well-known method of returning cash to shareholders stock buybacks are becoming increasingly important because of the sheer dollar volume of these transactions. A stock buyback is when companies purchase their own shares in the open market. Where the cash for these purchases comes from is important: it is either borrowed or generated from operating cash flow. For companies with strong credit ratings, borrowing to fund share buybacks can make financial sense.
There has been considerable debate as to whether or not the benefits of share buybacks are better for shareholders than simply rewarding them with direct cash payments through increased dividends. In short, “What is the best bang for the buck?” Some investors prefer the direct cash payments from dividends over buybacks.
Supporters of buybacks over dividends believe that buybacks are in fact valuable because they reduce the number of shares outstanding. This makes the remaining shares become more valuable because they now represent a greater percentage ownership in the company. However, this is not always the case. From the chart, we can see that large stock buybacks do not always correlate to great stock performance. For example, Safeway bought back over 40% of its shares outstanding in the ten year period from 2003 to 2012 but its stock price actually declined. The buyback history of the other companies shows that price performance and size of the buyback do not necessarily correlate well. This means that other factors such as profitability and industry conditions that impact stock performance can offset even substantial stock buybacks.
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In short, not all buybacks are the same. Some investors complain that buyback decisions are sometimes driven by companies whose executive teams have their compensation tied to changes in earnings per share (EPS). For example, some studies have found that a company that needs to meet a certain EPS target often turn to buybacks to hit its earnings target. Other times, companies buy back their shares to offset the shares that they issue to key employees as part of their compensation.
Too often, great excitement is generated by an announced buyback. What investors need to remember is that an announcement is an intention – not a promise – to buy back stock. According to data from Standard & Poor’s, of the 317 companies that repurchased shares in Q4 2012 only 98 actually reduced their share count while 203 of these buyers saw their share counts actually rise. This means that the companies were using the repurchases to offset shares issued; that is, buying shares with one hand and issuing more with the other.
Another weakness often pointed out in the buyback data is that too often companies buy back more shares near peaks in their share price rather than when the shares are at low points. This means that the buyback companies are not getting a “good bang for the buck.”
One of the strongest examples of buybacks that largely reflect money not well spent was in 2007 – just prior to the financial crisis. That year, U.S. companies set a record for buybacks as companies spent $589.1-billion. It seems that corporations and their boards that authorize buybacks tend to spend more on buybacks during booms and are reluctant or unable to do buybacks during downturns – when their share prices might reflect a greater bargain price. Too often, these misplaced buybacks actually destroy shareholder value.
While investors rightly focus on share buybacks as a potential positive for equity returns, not all buybacks are the same. Investors must try to sift through some of the noise that too often surrounds stock buybacks and be able to separate the wheat from the chaff.
Pacifica Partners Capital Management Inc.
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