Karl Geal-Otter, Pathfinder Asset Management
by Pathfinder Asset Management
Karl Geal-Otter, Pathfinder Asset Management
This is very much in vogue in the US. Share buybacks total US$750 billion year-to-date, already more than 2017’s full-year number. Goldman Sachs estimate it could reach US$1 trillion by year-end. Corporate tax cuts in the US have been the main ingredient fuelling the fire, combined with record levels of cash on hand at some of the world’s largest companies.
From an investor’s perspective buybacks can be broken into three groups depending on how deeply you investigate them – these are the “good-bad-good” of share buybacks.
When a company decides to buy back shares, it reduces the number of shares outstanding. This, in turn, drives up the price - a sugar rush for investors. This also increases earnings per share (albeit artificially), fuelling a perception of stronger earnings. All good, at a superficial level.
All sugar rushes are followed by a crash. For share buybacks, the crash is the perceived conflict of interest and manipulation. In the US, companies are required to report earnings quarterly, which increases the focus on near-term earnings at the expense of long-term investments.
One US study, between 1950 and 1970 – a period when companies began reporting more often – discovered significantly lower capital investment when reporting became more frequent. In other words, management teams focused on producing respectable quarterly earnings rather than deploying capital for long-term investment benefits – the birth of corporate short-termism.
Chief executives now rely heavily on stock performance and short-term earnings per share when determining their pay. This has created a conflict of interest between the short-term focused management teams and long-term focused investors. Using corporate funds to buy back stock (short-term share price sugar rush) at the cost of making long-term investments – is potentially a bad outcome for investors.
Using corporate funds to buy back stock and increase CEO pay makes for a great corporate bashing headline. However, the claim that buybacks are a misuse of corporate funds isn’t always supported by evidence. One survey found that most companies make share repurchases with residual cash flow after investment spending. This was supported by another study which showed buybacks increased when there were less high-quality investment opportunities.
What is important to this argument is how companies use excess cash after all value additive investments have been made. Management teams that hoard cash for “empire building” should be avoided. Despite holding almost US$6 billion of cash on its balance sheet in 2015, Yahoo was valued at less than the sum of its parts. Investors discounted Yahoo because they feared the company would spend its excess cash on value depleting projects.
This point is reinforced in research findings that $1 of cash was worth only $0.42 to $0.88 in a poorly governed company. Rather than hoarding cash, corporations with large cash holdings can return it to shareholders by way of a share buyback. Here, buybacks are a good investor outcome. Long-term results have been supportive – with companies that engage in buybacks outperforming their peers on average by 12.1% per annum in the ensuing 4 years.
Share buybacks cop a lot of bad press, but there is a strong argument they can add (or protect) long-term value for investors. It all depends on how deeply you investigate the outcomes.
Karl Geal-Otter is an investment analyst at Pathfinder Asset Management, a boutique responsible investment fund manager. This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.
Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz
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