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OPINION

Corporate cannibalism

Corporate cannibalism
January 10, 2019
Corporate cannibalism

 

Allegation 1: companies use buybacks to manipulate published figures and inflate executive pay

Buybacks reduce the number of shares in issue, so if earnings stay the same, the earnings per share (EPS) will increase. And if EPS is used as a performance condition, so the argument goes, then executives will receive a higher bonus and more shares from their long-term share awards. You’d hope that this would have been factored into the performance criteria (there’s little evidence that it has been), but in any case, fewer companies now rely on EPS as a performance condition.

Buybacks are also said to give a temporary fillip to the share price, because if EPS goes up and the price/earnings (PE) ratio stays constant, a higher share price will result. Since another common performance condition is total shareholder return (TSR, which tracks share price performance assuming dividends have been reinvested in the shares) this would also push up executive pay. But that’s a more dubious claim now that most senior executives are blocked from selling their shares for at least a couple of years after receiving them. Pushing up the share price when awards vest would just saddle them with a higher tax bill.

 

Allegation 2: buybacks stifle investment

Most companies have limited resources, so how true is it that funds that should have been invested in products or services have been diverted into buybacks instead? This, some believe, could help to explain the general lack of investment and static productivity in UK businesses. 

The counter view is that buybacks are a symptom, not the cause. Companies would invest more if they could see realistic value-creating opportunities and had more confidence in the future. As growth prospects diminish, they need less capital so it makes sense for them to buy some of it back.  

 

Allegation 3: buybacks are becoming more widespread

The US leads the charge here, and JPMorgan estimates that, since 2008, buybacks have totalled $4.5 trillion, equivalent to almost a third of the increase in the market cap of US stocks during that time. Sources vary, but according to the Global Banking and Finance Review, it seems that companies bought shares worth $640bn in 2017 and about $800bn in 2018. Notable purchasers are Apple (US:AAPL), Oracle (US:ORCL) and JPMorgan (US:JPM). Goldman Sachs expects buybacks to climb to over $940bn in 2019.

The uptick has been attributed to the Trump corporate tax cut (from 35 per cent to 21 per cent) that has led to waves of cash (estimated at $2.5bn so far) being repatriated to the US. US companies are now said to spend more in buying back their own shares than investing in their businesses and, while over 30 per cent of buybacks were financed by debt in 2017, less than 15 per cent have been in 2018. The pattern of these cash movements has helped drive the ups and downs of stock markets around the world.

Those are heady numbers, but what about the UK? We’ve had no Trump tax reforms, of course, and whereas (for historic tax reasons) buybacks are embedded in the US psyche, until recently UK companies were more inclined to return funds to shareholders as dividends. As you’d expect, the scale here is more modest, but even so, it was the increase in total UK buybacks (to £15bn in 2017) that helped prompt the government review.  

And this trend has continued. Shell (RDSB) has said that its buybacks will total at least $25bn in 2018-20 and Lloyds Banking (LLOY) is said to be planning to double its buybacks in 2019 (to £2bn). In July, it was reported that Glencore (GLEN) had “responded to a sharp fall in its stock price” by announcing plans to repurchase up to $1bn of its shares. And more recently Standard Chartered (STAN) was rumoured to be drawing up plans for buybacks “to revive its flagging share price”.

 

Allegation 4: buybacks inflate share prices

Do buybacks boost share prices? Intuitively, a company that steps into the market will be an extra buyer, so it follows that you’d expect a falling share price to be stabilised, which ought to reduce volatility overall. If a company has excess cash, or can borrow cheaply, you’d also expect that buying its own shares would make it financially more efficient. And that too ought to boost its share price. 

That chimes with the view that executives time buybacks to lift the share price when performance conditions are being assessed or when they wish to sell shares. But others interpret buybacks as signalling a lack of internal investment opportunities and so, unless the company is highly cash generative, they are an admission that growth has become harder to come by. This capitulation knocks sentiment, they argue. Dividends would benefit share prices more.

Whatever the short-term effect, in the long run, companies have an unhappy knack of paying too much for their own shares. That’s because the time when they tend to have plenty of cash is around the peak of the business cycle, when apparently sustainable growth has led to high share prices. It’s also when they come under shareholder pressure to return the cash. Investors are wary of acquisitions, particularly 'transformational' ones, and buybacks are seen as a way of imposing discipline on potentially spendthrift chief executives.

The contrarian time to buy is when prices are low. But that’s when confidence is also low and when companies are least likely to have surplus cash. And a strategy of borrowing to buy shares, especially during a downturn, is hardly a prudent way to manage risk. 

Glencore famously bought back shares in 2014, only to have to cancel its dividend and raise equity the following year when commodity prices crashed – helping to reinforce the view that buybacks pay some shareholders to go away at the expense of those who remain.

 

Allegation 5: despite their detailed knowledge, executives are hopeless at timing share purchases

To counter this, some senior executives delegate purchase decisions to others. Both Diageo (DGE) and RELX (REL) have buyback programmes that are 'non-discretionary', which normally means they leave it to their brokers to decide when to buy. That also ought to rebuff the allegation that executives use buybacks to manipulate EPS and the share price, but some say that this is not good enough.

The priority should be to invest in their businesses, provided that the expected returns exceed the cost of capital employed. Only then should they think about buybacks, for which the funding should come from surplus cash rather than increased debt. And watch the share price, shareholders say. Buy back the shares when the price is less than the intrinsic value of the company per share, or provided that a better return could not be obtained elsewhere. When the share price rises beyond this, let’s have a special dividend instead. That, broadly, is what Next (NXT) consistently does. It has other criteria too, such as requiring long-term growth and keeping its dividends in line with EPS. Berkeley Group (BKG) also switched from paying dividends to buying its own shares when the price dived in 2016. 

Unless companies have thought through their buyback policy, they’ll be suspected of announcing what they’ll spend on buybacks and then naively buying their shares almost regardless of price, until those funds are all gone. 

 

Allegation 6: nobody is accountable for buybacks

In the UK, institutions have clear guidelines, compiled by the Investment Association. They say: “Companies should disclose in their next Annual Report the justification for any own share purchases made in the previous year, including an explanation of why this method of returning capital to shareholders was decided upon. In this context, companies should discuss the effect share buybacks have on earnings per share (EPS), total shareholder return (TSR) and net asset value (NAV) per share. EPS and TSR targets under both short and long-term incentive schemes should take account of the effect of share buybacks.”

True, these are voluntary guidelines.  But the evidence from AGMs this year is that fund managers and other investors are becoming more strident in their criticism of companies. There seems to be a greater willingness to hold them to account – but how high are buybacks on their radar?

 

Scapegoats

So what’s the verdict? The government chose PwC and Professor Alex Edmans, an academic at London Business School, to conduct the buyback research.  Both had previously questioned the effectiveness of bonuses and share awards. Perhaps that was why they were selected. 

Writing in the Harvard Business Review in 2017, Professor Edmans said that if there is a lack of investment, “buybacks are a red herring”. The real cause boils down to “myopic incentives”. These encourage renegade chief executives to cut investment to “boost the short-term share price” and game their earnings targets “at the expense of long-term value”. Blame the directors then for poor corporate governance. But Professor Edmans has not yet said how common these myopic tendencies are.

Against this, he has also warned against turning incentives, as well as buybacks, into scapegoats. His research suggests that performance-related pay is essential to keep executives focused on what is important in their company. Scrap bonuses and share awards and you attract “coasters who desire a quiet life”, with the result that productivity and profitability suffers. The art lies in getting the performance conditions right.    

Whatever the findings, they must have been hefty, or maybe controversial, because almost a year has passed since the report was commissioned. Nor does there seem to be a target date for when it will be published. Anyone would think that the government has been distracted by other things.