Share buybacks used to be something of a US phenomenon, like baby showers and Halloween. But like those traditions, they have crossed the Atlantic and taken hold. According to research by Janus Henderson, the value of UK buybacks almost tripled between 2021 and 2022 to $70.5bn (£56.5bn). This wasn’t an anomaly: since 2016, payouts have increased more than seven-fold.
A similar pattern can be seen globally. Every region and almost every sector has increased its use of buybacks, which have tripled in value since 2012. Around the world, they now amount to 94 per cent of dividends, compared with little over 50 per cent a decade ago, as per Janus Henderson.
The question is: are investors benefiting? Or are there better uses of company cash?
Cash overflow
Buybacks involve companies purchasing their own stock in order to reduce the number of the company's shares in circulation. While they are designed to remunerate shareholders, they are less straightforward than dividends as the money isn’t distributed evenly: only those who sell get the cash.
Those who choose to hold, meanwhile, end up owning a bigger chunk of the business than they did before and – in theory at least – benefit from a share price boost.
This boost can occur because, by reducing the number of shares in issue, the management team automatically increases the company’s earnings per share (EPS) figure. This, in turn, lowers its price/earnings (PE) ratio, which is calculated by dividing share price by EPS. As PE ratios are commonly used to assess value, a lower multiple is likely to lure in more investors, who then push the price up.
This isn’t the only perk. Buybacks can be beneficial from a dividend perspective too, as a reduction in outstanding stock also lifts the dividend per share. In other words, those who choose to hold are entitled to a bigger portion of future payouts – although companies sometimes focus on total payouts and so will use buybacks to cut back on dividend growth.
US companies are still responsible for the majority of buybacks, fuelled by the likes of Meta (US:META) and Alphabet (US:GOOGL), which have never paid dividends. However, UK companies that are unhappy with their valuations are helping to close the gap.
“It’s partly a feeling that they need to attract buyers,” said Ben Lofthouse, head of global equity income at Janus Henderson.
“We are reading articles about the UK being unloved and falling as a percentage of market cap. And the more we move into a passive world, the more the money is moving into very large-cap stocks. There is an element of companies feeling that somebody needs to be buying their stock, and why shouldn’t it be them?”
Buying investors
It’s a good question – and one that generates an indignant response from some investors. For while buybacks are on the rise, they are not universally popular.
Returning cash to shareholders is always done at the expense of something else, be it investment, M&A or deleveraging. Buybacks, therefore, inevitably throw a company’s capital allocation policy into the spotlight.
Recently, the debate has centred around oil companies, which made the largest contribution to buyback growth in 2022. They spent $135bn on their own shares, four times more than in 2021. Shell (SHEL) and BP (BP.) are still buying billions of dollars of their own shares a quarter, and HSBC forecasts that Shell will continue buying back the equivalent of 6.5 per cent of its market capitalisation annually.
The International Energy Agency flagged that the sector's huge cash returns came at the expense of investment in clean technologies, which received “only a small fraction” of the “record cash windfall”.
This argument is equally applicable to dividends, of course. However, buybacks throw up specific issues too – namely, the problem of timing. “Every time management does a buyback, it is making a call on whether the current valuation of stock is correct or not,” noted Liberum analyst Anubhav Malhotra.
"Best practice would be to calculate an equivalent rate of return from that investment into buybacks, which will help objectively to assess whether the buyback is being done at a time when the shares are overvalued or undervalued.”
Best practice isn't always followed, however, and cycles can turn quickly. Mining and trading giant Glencore (GLEN), for example, announced a $1bn buyback scheme in August 2014 when its valuation was riding high. By the end of 2015, shares had crashed, it had cancelled its dividend and announced a $2.5bn equity placement.
Burnt crust
Pizza giant Domino’s (DOM) is another example of overdone buybacks. Analysts flagged concerns about the group’s buyback plans in 2018, suggesting that repurchasing shares at a PE ratio of 25 was unwise – particularly as Domino’s was acquiring businesses in underdeveloped markets at the same time.
Since then, the company has spent £250mn buying back its own stock, according to FactSet, and has more purchases lined up. However, between 2018 and 2023 profits have struggled and the group’s total return has fallen. What’s more, the group is using debt – as opposed to leftover cash – to fund the payouts. In March, it reported that increased returns to shareholders had led to net debt of £253mn and a leverage ratio of 2.06 times.
Given the rising cost of borrowing, and the shareholder returns achieved so far, it’s hard not to be sceptical about the strategy.
It is worth noting here that buybacks can also benefit management teams. The performance of chief executives and chief financial officers is often judged on EPS growth. Last year at Domino’s, for example, 70 per cent of the long-term incentive plan (LTIP) awards made were subject to EPS targets. The other 30 per cent was based on shareholder returns.
Earlier this year, the buyback doubters enjoyed a true I-told-you-so moment. US home goods chain Bed Bath & Beyond filed for bankruptcy in April, after years of falling sales and mounting debt. Despite its long-standing operational problems, however, the group had spent over $7.6bn on share buybacks between 2013 and 2022, compared with free cash flow of $5.3bn. As the group hurtled towards disaster in 2022, and free cash flow turned negative, it spent $590mn repurchasing its own shares.
Best in show
At the opposite end of the spectrum, however, there is UK retailer Next (NXT). Next was among the first UK companies to start buying back its own shares, and has been doing so for more than 20 years. Since 2000, the number of shares in issue have fallen from 340mn to just 128mn.
Under the watchful eye of chief executive Lord Simon Wolfson, Next follows a list of strict company rules. These include only ever using surplus cash, as opposed to debt, and making sure that investment is prioritised over payouts.
The retailer also has a method for calculating an “equivalent rate of return” which compares the earnings enhancement of a buyback with the profit that would have to be achieved from investing the cash elsewhere. If the equivalent rate of return falls below a certain level, management is not interested.
Over the past 20 years, this approach has generally paid off: management has stuck to its rules and total returns have kept climbing. In the past five years, however, the strategy has become less sure-footed, as sales growth has stalled and returns have proved “unexciting”. Nevertheless, total returns have increased in the period and investors can take comfort in the fact that Next will carefully weigh up the pros and cons of future buybacks. Unfortunately, the same cannot be said for all companies.
It's easy to become too negative, however. "The rapid growth in buybacks in the past three years reflects a strong profit and free cash flow performance and a willingness to reward shareholders without setting unintended expectations for dividends," said Janus Henderson's Lofthouse. After three years of turmoil, profit, cash and rewards are more than many investors hoped for.
