Tuesday, September 23, 2014

Share buybacks - cause for concern?

Several recent articles (in The Economist, the Financial Times and the Wall Street Journal) highlight the spate of buybacks by blue chip companies over the last year, and raise some concerns arising out of this seemingly shareholder-friendly trend.

The companies in the S&P 500 index bought US$500 billion of their own shares in 2013, close to the high reached in the bubble year of 2007. This comprises 33 cents of every dollar of cashflow generated by these companies. Even in Europe and Asia (Japan, in particular), buybacks by companies have seen an upward trend. Given the cash reserves which have developed at many blue-chip companies since the 2008 crisis, the current low interest rate environment and limited investment opportunities, returning some of this surplus cash to shareholders may be viewed as a positive development – indeed the buybacks at some companies like Apple are in response to aggressive campaigns by activist shareholders.

However, there are a few major concerns with this recent trend – relating both to the underlying reasons for some of these buybacks and also their potential impact.

Lack of long term investment

One direct consequence of returning capital to shareholders is that the capital is no longer available for investing in the company, whether in improved facilities, distribution networks, or R&D. This has led some commentators to suggest that the long term prospects of these companies are being adversely affected by utilising surplus cash in buying back shares.

However, although this concern is valid (especially when combined with the second concern discussed below), many of the blue-chip companies returning capital are digital or internet companies (such as Apple, Intel, Cisco or Microsoft) which do not need the sort of heavy capital investment required by their counterparts in the manufacturing industry. Therefore, the fact that greater capital is being returned to shareholders does not necessarily translate into under-investment in the future of the business.

Self-serving motives

A more significant concern over the spate of buybacks is that they may be prompted by short-termism and the self-interest of those occupying management positions, rather than the long term interest of shareholders.

Share buybacks both increase the share price and reduce the number of shares in issue; the latter directly increasing the earnings-per-share (EPS) ratio of the company. Since the remuneration of management may comprise a stock-option plan and is also often linked to the EPS ratio, there is thus a self-serving motive for implementing buyback programmes. This leads to the concern that the management of some of these entities are moving away from ‘value creation’ to ‘value stripping’, benefiting short term shareholders at the expense of those investing in the companies for the long term.

Introducing instability 

Finally, the trend of buybacks poses a serious risk of introducing instability to the companies and the market as a whole.

According to The Economist, figures reveal that over the last year for non-financial firms in the S&P 500 index, buy-backs, dividends and capital investment added up to 101% of operating cashflow – suggesting that their books were balanced. However, this figure is misleading due the inclusion of a handful of giant pharmaceutical and technology firms. If these cash-rich entities are excluded, two-fifths of the S&P 500 companies spent more than their entire cashflow on dividends, buybacks and capital investment, thereby adding to their net debt. Further, even for cash-rich companies like Apple, the complex US tax structure means that most of the surplus cash is located offshore and is not utilised for funding buybacks. As a result, Apple borrowed $12 billion in the US last year to help fund buy-backs despite having $132 billion of cash sitting abroad. This trend is not limited to the last year either – an article in the September 2014 edition of the Harvard Business Review indicates that between 2003 and 2012, the top 449 companies in the S&P 500 spent 91 per cent of net income on buybacks and dividend payouts.

Not only do these excessive buybacks and dividend payouts impact future prospects of the companies concerned, but may also introduce instability to the market through inflated share prices and increasing corporate debt. Further, it is ironical that one of the major reasons for low interest rates is to prompt greater investment by companies into the economy – something that is hardly being achieved if companies utilise the low rates to borrow cash in order to fund share buyback schemes.

Looking forward

Most jurisdictions already impose broad limits on capital reduction schemes – either in the form of shareholder approvals or by capping the extent of buybacks in terms of trading volumes. However, given the events over the last year, these limits do not appear to be sufficient. Recommendations for further legislative change include improved corporate governance and shareholder influence over remuneration (to address the concern over self-serving motives). Even changes like simplifying the US tax system could have the effect of bringing back more surplus cash to the US, thereby limiting the building up of corporate credit.

Further, The Economist suggests that the buyback boom may now be peaking, with companies such as Exxon, Tesla and Amazon proposing injections of capital into their businesses. This is perhaps prompted by the realisation of institutional shareholders that high short term returns at the cost of investing targeting long term growth are not necessarily in their best interest.  

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