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Buy-backs 1: The case in favour

Created:
9 July 2008
Written by:
Alistair Blair

My column two weeks ago about the banks' disastrous share buy-backs in recent years brought forth a lot of e-mails from readers about buy-backs in general. It is clear that buy-backs bamboozle many private investors and enrage a fair minority. Buy-backs were all but illegal in the UK until about 1985 and it took a good decade or more for them to catch on after that. But, over the last few years, the buy-back has advanced from obscure accoutrement to mainstream must-have.

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Buy-backs are not good for everybody, nor at all times. But, in my view, the right to buy back shares and cancel them is essentially a good thing. After all, 40 years ago, companies that piled up more cash than they needed in their main business often disgorged it into acquisitions - frequently in areas unrelated to their expertise - which often proved disappointing or worse. They still do that, of course, but not on the same scale. Now, they at least have the option of returning this cash to shareholders via a buy-back.

And they have been returning it in bucket-loads. BP has been even more "generous" than the banks, having spent over £20bn on buy-backs in recent years. As one reader observed: "That's more than the London Olympics are going to cost." But one must not overlook the gargantuan scale of BP: £20bn bought less than 20 per cent of its shares.

Nevertheless, the man on the Clapham omnibus is always going to struggle with buy-backs. The subject has no parallel in personal life. If an individual accumulates money, he can hoard, spend or invest it, or give it away. The buy-back option does not arise. Why does it arise for companies? Because companies and investment markets are driven to a significant extent by return on equity. The man on the Clapham omnibus does understand this. If I have £1bn of shareholder funds and my business operations earn 15 per cent a year on those funds, on average, taking in the ups and downs, then I'm probably fairly happy and so are my shareholders. But if I can't expand my business readily, and therefore do not need my profits for reinvestment, then my return on equity will inevitably decline. My earnings per share will still be on the rise, but at a slower rate than previously.

Say I pay half of my earnings out as dividends, then I am accumulating £75m a year for which I have no obvious use. After five years, I will have shareholder funds of £1.375bn. I'm still earning 15 per cent on the first £1bn, but on the remainder, I am merely earning 5 per cent from bank deposits or money markets. So, whereas I used to make £150m on £1bn, I am now making only £159m on £1.375bn. Oh dear, my return on equity has fallen to 11.6 per cent. My shareholders are less happy. And the situation will deteriorate.

Readers will be quick to observe that the buy-backs are rarely financed from cash on deposit. Indeed, they are often carried out by companies that already have borrowings instead of cash, and are now borrowing further money to finance the buy-back. But the same argument applies, if all other things are equal. Suppose I had £200m of borrowings combined with £800m of shareholder funds. I still earn £150m from my operations, but I pay £14m in interest, leaving £136m as my return on equity. The effect of the borrowings is to give me a higher starting level of return on equity, of 17 per cent (136/800). If I was paying half my earnings out as dividends, I am accumulating £68m a year, which will rapidly pay off my borrowings and reduce my return on equity in just the same way as the earlier case.

Now you could say, "why doesn't the company increase its dividend?" There are two answers. First, the accumulation of generous amounts of spare cash is rarely a long-lasting situation. So a boost in dividends would likely be followed by a reduction. But it is an article of faith for most businessmen and, indeed, most investors, that reducing dividends is bad. So I would not want to put myself in a position where I expected to reduce dividends. "Sure, but how about a special dividend? We recognise that special dividends are one-offs." But all dividends, including special dividends, involve paying the taxman his due. Buy-backs cut the taxman out. That's good for all shareholders, whether they participate in the buy-back or not.

Hence the buy-back. Next week: Abuse of buy-backs

MORE FROM ALISTAIR BLAIR...

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Alistair Blair is a past winner of the Business Writer of the Year Award, and has worked in investment banking and fund management.

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