If it is very cheap to borrow money, directors may be inclined to impress investors and game their incentive schemes by buying back more shares than is wise. The directors taking these decisions might believe that cheap borrowings and strong cash flows will continue, bringing shareholder funds back into line with borrowings in due course. If they're right, they'll look smart. If they're wrong, the consequences will be expensive (more so for shareholders than for directors - but that's another story).
There is also the huge issue of the price at which shares should be bought back. If you, or I, or the directors knew this price, we would be wondering what to do with the untold billions we had amassed. As mere mortals, however, directors are inclined to believe that if their shares seem to be valued on a similar basis to those of comparable companies - and these prices are not clearly out of line with historical precedent - then the current price is the right price for a share buy-back. If a global share price correction or an unexpected trading hiccup is around the corner, this calculation will be proved false, but if you think directors should invariably foresee such events, then I feel you are over-optimistic.
The buyback binge
It has, of course, been exceedingly cheap to borrow money for most of the last six years, and many companies mounted large share buy-backs - over £60bn in the UK during 2006 and 2007, compared with about £120bn paid in dividends. Moreover - wouldn't you just know it? - a big share-price correction seems to be unfolding right now, which even before the precipice - if there is going to be one - . The banks, which had been happy to ignore the fact that borrowing conditions had lost touch with historical precedent, and are now following up £10-a-share buy-backs with £2 share issues, are clearly guilty of abusing share buy-backs. But the case is not proven in the case of, say, BP or even Marks and Spencer, notwithstanding discrepancies between their current share prices and the prices of some of their buy-backs. If these companies get through the coming recession in a workmanlike manner, the fact that they are using less shareholder capital will prove beneficial in the long term.
I accept that this will seem blasé to many readers, including Ken Mitchell, who is a regular correspondent of mine on this issue. He argues: "There is no evidence to show that the benefits you describe ever feed through to the share price, except if the buy-backs are undertaken when the company feels their share price is far too low - and then if the company is right its shares will surely recover anyway? … evidence from Morgan Stanley shows that the share prices of companies indulging in share buy-backs underperform those that did not."
But a share price reflects many more factors than a buy-back and I feel Ken Mitchell is inclined to give undue prominence to just this one. The Morgan Stanley evidence was set out in a circular issued in May 2007, entitled 'Dividends are More Effective Than Buybacks'. This interesting piece of work does not argue that buy-backs are inefficient for shareholders. It simply demonstrates that companies which raise their regular dividends are better investments than those carrying out buy-backs.
Dividends = growth
And that's exactly as it should be: companies which are buying back their shares are in effect stating that they cannot invest their spare cash flow effectively. Such companies will experience decelerating return on equity. Although buy-backs ameliorate this trend, they cannot reverse it. Morgan Stanley's finding that "the average stock that undertakes a share buyback programme underperforms the market" is precisely what one would expect (although this finding was less convincing when the data was based on median performance rather than average performance… this means that the giant buy-back programmes such as BP's and Vodafone's are not without merit).
By contrast, companies that are increasing dividends fastest are, of course, the very companies we should all be invested in. Morgan Stanley found that companies demonstrating dividend growth outperformed those making buy-backs. Except in falling markets. The time for a spot of buy-back genius is probably emerging.
