More companies are buying back their shares. According to The Economist, the companies in Standard & Poor’s 500-stock index spent $500 billion on share buybacks in 2013. The trouble is, buybacks often come at the expense of dividends. Buybacks account for 60 per cent of each dollar returned to shareholders. Dividends account for only 40 per cent.
Buybacks have both positive and negative aspects, which The Economist outlines.
One positive aspect is that they return capital to selling shareholders. This benefits the remaining shareholders. Buybacks support the share price and raise earnings per share.
A second positive aspect is that buybacks are flexible. If a company’s cash flow jumps, it can buy back more shares. If cash flow later drops, the company can buy back fewer shares. When a company raises its dividend, by contrast, investors expect it to at least maintain the higher rate of dividends—even if its cash flow falls. Then again, ‘special’ dividends companies occasionally pay also offer flexibility.
Market timing doesn’t work
A third positive aspect is that share buybacks show that management considers the shares undervalued. But managements have poor records in this regard. Many studies have shown that most investors fail to correctly time the market. The same is true of managements buying back shares.
Share repurchases peaked in 2007 as share prices also peaked. The Economist writes that “few firms bought in 2009, when shares were dirt-cheap. In the six months to May, 2008, as Lehman Brothers faced a cash crunch that would end in its bankruptcy, it blew $1 billion on buying its shares.”
A fourth positive aspect is that buybacks encourage discipline. The Economist writes, “Firms cannot now hoard cash or invest it sloppily. Instead they face a contest for resources with their owners.” In fact, activist shareholders are demanding that companies sitting on piles of cash do more buybacks and raise their dividends. Also, companies have less scope to, say, buy jets for the benefit of management.
Buybacks also have some negatives
One negative aspect of share buybacks is that it drains cash that companies could invest. According to The Economist, IBM spends twice as much on buybacks as it does on research and development.
A second negative aspect of buybacks is that managements sometimes do it just to raise their pay. About half of all American managers are paid partly for achieving certain earnings per share targets. Since buybacks raise earnings per share, management has an incentive to overdo buybacks.
It gets worse. The Economist writes, “Pay plans can corrupt managers’ motives. By buying existing shares they can offset the effect of new ones created for their personal stock-option plans. Cash leaves the firm for their pockets without being booked as a cost or reducing earnings per share.”
A third negative aspect of share buybacks is that many companies overdo it. According to The Economist, in 2013 38 per cent of American publicly-traded companies used more than their entire cash flow for buybacks. This cannot continue for long.
Borrowing for buybacks raises risk
A fourth negative aspect of share buybacks is that many companies borrow money to finance them. This debt weakens the companies’ balance sheets and increases their risk.
Managements of companies do not deserve all the blame. The fact is, short-term investors and institutional investors often try to loot companies before moving on. The Economist quotes Simon Henry, the chief financial officer at Shell as saying, “The longevity of the firm is what matters. . . . executives need to hold their nerve against short-term pressure so that they can invest for the long run.”
Changes in the economy have tended to increase most companies’ cash flow. The growth in online shopping, for example, has reduced the need for retailers to invest in new ‘bricks and mortar’ stores. The growth in services relative to manufacturing is another example. Service companies usually require less capital than manufacturers.
On balancing these positives and negatives, we still prefer higher dividends to share buybacks.
The Investment Reporter, MPL Communications Inc.
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