Join our community of smart investors
OPINION

buyback mountain

buyback mountain
October 31, 2014
buyback mountain

Across the pond, the sums involved in this practice have been truly astronomical. S&P 500 constituents are on track to spend over $900bn (£559bn) on share buybacks and dividends this year. Astonishingly, this equates to around 95 per cent of aggregate earnings. And according to recent research published by US brokerage firm LPL Financial, companies purchasing their own shares constitute the single biggest category of stock buyers today. Our editor's concerns are borne out further by the latest Buyback Review Quarterly from US-based FactSet Research Systems, which shows that the ratio of buybacks to free cash flow now stands at its highest level since the third quarter of 2008 - and we all know what happened after that.

Just last week, US pharmaceutical giant Pfizer (US: PFC) still smarting from this year's aborted takeover bid for limey rival AstraZeneca (AZN), signed off on a new $11bn share buyback plan. Meanwhile, the billionaire investor activist, Carl Icahn, has been making overtures to Apple (US: AAPL) in a bid to get the tech-geek icon to accelerate its $30bn capital return plan. Of course, no one could ever doubt Apple's ability to grow organic earnings and cash flows, but the issue highlights how some strategic investors with deep pockets can place undue pressure on a board to take decisions that aren't necessarily in the best interests of long-term shareholders. Somewhat bizarrely, Apple took the decision to borrow money for a previous $60bn buyback, as most of its cash was locked-up in overseas locales and Apple didn't want to pay the taxes required to repatriate the money. It could be argued that the greatest beneficiaries of buybacks are short-term shareholders such as Mr Icahn - it's not as if he has made any meaningful contribution to Apple's products and profits down the years.

Closer to home, the share price of Rolls-Royce (RR.) took a battering earlier this month after the engineer issued its second profit warning of 2014. But the group still felt it prudent to reiterate a pledge to return around £1bn to investors through a buyback programme once it completes the sale of its gas-turbine and compressor business to Siemens. One would think that management had more pressing issues.

Of course, if you've made a premium on the back of a buyback programme over the past couple of years, you're probably wondering what's all the fuss is about? At the end of the day, it's your capital, after all. But it must raise doubts over the ability of public companies to drive underlying earnings growth, particularly if liquidity starts to drain out of the wider economy. Anyway, the practice had its detractors long before central banks cranked-up the printing presses, and long before we entered into an epoch defined by so-called secular stagnation.

Critics take the view that while buybacks aren't necessarily misguided, all too often they're driven by skewed short-term incentives. Instead of allocating capital to expand a business, executives will use surplus capital - or even increase borrowing - in order to manipulate a company's share price. Obviously, the initiation of a buyback programme will initially support a company's share price through increased demand for its shares in the market. And it obviously follows that once the shares are cancelled; earnings per share will invariably tick-up even if net profitability is static. The practice can also help to inflate a company's dividend yield, although, admittedly, this metric is essentially a function of market price.

Regrettably, far too many listed companies still predicate their director remuneration and incentive packages on nominal EPS returns, which explains why sound capital allocation sometimes gives way to expediency. In a low-growth economy, an artificially inflated earnings profile might also help chief executives avoid scrutiny from institutional shareholders and advisory boards, albeit temporarily. However, some executives might well argue that the incentive provided by today's ultra-low interest rate environment is at the heart of the issue. Put simply, debt financing is cheap; while the cost of equity capital needed for long-term investment is still high. This, in itself, could act as catalyst for companies to borrow in order to carry out buybacks. Call me old-fashioned, but wouldn't the long-term interests of shareholders be better served by directors putting their efforts into devising strategies to grow businesses rather than simply tinkering with earnings metrics?