After seeking shareholder permission, companies that find themselves over capitalized can buy back some of their shares in the marketplace. Like directors dealings, these buybacks must be suspended during the closed period of two months leading up to their results. This can provide an opportunity for traders to take advantage of. For example by establishing a short position just as the buy-back is finishing, closing the short during the anticipated share weakness leading up to the results and perhaps establishing a long position in readiness for renewed share price support when the buyback recommences.
Now not all buybacks are done for the same reason, so it pays to research the company’s position and possible purpose in trying this ploy before assuming that the standard stock variations will apply. For instance, recently companies have had a surplus of cash caused by government rescues, and a buyback is an unimaginative way in which they can use the funds. The purchase should result in a temporary increase in value of the shares, but bear in mind that the longer term prospects may not be so good if the best use that the company has for the money is buying back their own shares, and they do not spend the money on acquisitions or research and development.
“If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.” – Warren Buffett
“If you are buying stock in a company because of its buybacks, but they are issuing as much stock in stock based compensation, then YOU are the buyback”
The point of buybacks is when that use of capital is better than investing it elsewhere. ie you create more shareholder value than reinvesting it in the business. So most BoD will sanction it if, in their view, there is a big disconnect between the fundamental value of the business and the share price. However, that also creates a large demand for shares that should absorb any weak holder selling and thus push the price up or narrow the discount to NAV but this effect seems extraordinarily weak at the moment.
Some companies seem to have their priorities wrong in the use they make of their funds. For instance, General Motors have spent more than $20 billion on buybacks since 1986, and if they had instead invested the funds they would have had $35 billion more in cash at the time they were declared bankrupt and taken over by the US Government. Eight of the banks receiving bailout funds from the US Government had spent nearly $200 billion on share buyback schemes before they found themselves in trouble. So a buyback is not always a wise decision on the part of the company’s management.
Sometimes companies back themselves into a corner and almost have to start buyback schemes because of the employee benefit programs that they have. Employee Stock Ownership Programs (ESOPs) give workers rights to own shares, and if too many shares are issued they suffer from dilution, and devalue the stock. The answer to this is a buyback scheme, but this needs to be done to bolster the stock values regardless of other considerations. Cisco and Dell Computer are examples of this way of thinking.
Buybacks Used to Be Illegal in the Past
For a very long time it was illegal for companies to purchase their own shares. It has done a great deal of harm to company health that governments around the world have changed the law to permit such purchases in order to encourage companies to list and stylized in their jurisdictions. Management love it as it opens the way to financial manipulation to achieve bonus targets, and financial manipulation (along with excessive debt rather than equity financing) to flatter share prices artificially at the expense of safety of the balance sheet and accounting transparency.
Nor, contrary to their belief, are many directors of trading companies blessed with the investment skills of a Warren Buffett. If they were, they would be running BH, not a trading company. Consequently, a high proportion of share buy backs are badly timed and conducted at excessive prices. Very often the current price of borrowing money is the critical factor rather than a reliable assessment that the market has undervalued the shares. As we have seen, confidence in what money will cost to borrow in months or years ahead is also often misplaced.
The point of buy backs is that reinvesting in the shares will give a greater return than reinvesting in the business. Whether this has been achieved or not can only be said many years in the future, when we can see if shares have been bought cheaply and what investing opportunities have been over the last few years. The point of a share buy back is not (or probably more accurately should not) be to cause a short-term pop in the share price. Therefore this is probably not a good metric to judge whether the buy back announcement is a good idea.
My Reservation on Buybacks
Logically, if a company engages in buying its own shares, it should do so only when they are oversold and present value to a purchaser. It follows from that that if the company is engaged in seeking to add value to its remaining shares by purchasing some of its own shares, it needs to consider first whether the purchase of shares in other companies would add more value (as it would if it identifies another company, operating in any field, whose shares are more deeply undervalued or offer better future prospects than its own). That is the business of an investment trust, not a trading company. When we buy shares in a trading company, we invest in the business and the expertise of the management to operate that business profitably. We do not buy the shares in an Oil and Gas producer for the skills of the management to play the stock market.
If a company has excess capital, capital which it does not require for the purposes of its business, it should return that capital to the shareholders by way of special dividends or return of capital. The shareholders can then make their own investment decisions whether to use the money to buy more shares in the company (as they probably will if THEY conclude that the shares are undervalued) or shares of some other company THEY rate more highly at the prevailing share prices, or spend it on beer and fags.
As investors, we look at the entire field and ask ourselves ‘is sector X or sector Y or Z the place to be at present?’ and ‘within that sector, is company A or company B or C the vehicle with the best prospects?’. A company deciding to buy its own shares asks none of those questions. Shell for example no doubt concluded that it would be beneficial to its shareholders to buy in Shell shares, but it will NOT have asked itself whether a better return would be obtained by using the money to buy shares in AstraZeneca (different sector), or even BP (same sector), as an individual investor or investment trust can and does do.
To go back to my earlier example, if Shell returns capital to me, I can use that money to buy more Shell shares, or AZN or BP or anything else. Shell merely asks itself ‘is it better for the shareholders that this surplus capitalism spent on buying Shell shares than lying in our bank account?’, NOT ‘are Shell shares the best shares on the market at their current price?’. Maybe I shall conclude that Shell is the best show in town and buy more Shell, maybe I shall decide that something else looks a better bet. I should have that choice as to the deployment of capital Shell deems surplus to its business requirements. That is not a decision which is even open to Shell, and even if it was it should be a decision for me as an investor to make, not for the management of an oil business to make for me.
Why Buybacks Can Be A Bad Idea for Shareholders
- Buybacks are proof a company has stopped innovating and has no ideas of how to get better returns on their cash.
- Technology companies in the USA are very fond of doing buybacks to ‘enhance’ value for shareholders. No mention of how much of the money towards buybacks was simply to offset the stock options granted to the executives of these companies. It was probably the lion’s share of the $ spent.
- And especially the case with high-tech companies who issue millions of shares to employees. Those bought back stocks are not actually “retired” – they are reused for a total package of employee compensation.
Buybacks are necessary because some companies grant tons of options. Massive selling by the insiders could easily erode stock price if companies did not do massive buyback. So, they may not necessary increase stock value but to prevent big drop so the price can be massaged to no effect.
The Supposed Logic of Buybacks
When a company buys back shares, it reduces the number of shares outstanding, which increases the size of dividends for the remaining stockholders. CEOs are often judged by the perceived profitability, for which one of the metrics is the size of dividend, and from such judgments come the bonus payments, thus it is in the managements personal interest to take steps to reduce the number of publicly owned shares.
In general, buybacks can be used to try and change the markets perception of the company. One way of implementing a buyback is to offer to buy shares from existing shareholders, and this is usually at a higher than market price in order to tempt them to sell. So the shares become perceived as being of a higher value. Apart from reducing the dilution of the number of shares, and increasing dividends, this is a way in which companies can set their own share values for investors to consider.
