THE wild gyrations in the stock market since January cast the high volume of share buybacks in 2015 in a fascinating light. Everyone was aware that heady market valuations last year reflected central bank intervention in the markets, which ought to have been a warning to boards contemplating buybacks.
Yet this did not prevent US companies spending more than $700bn on their own shares. In Europe volumes were smaller, but not insignificant. The big question is why institutional investors do not blow the whistle on what all too often turns out to be an exercise in value destruction.
There are two semi-respectable reasons for share buybacks. One is that they are part of a normal capital allocation process. If the potential return on purchasing the shares is higher than on an investment in the business then a buyback might seem logical. Yet it also seems counter- intuitive since, unless the shares are undervalued, which implies an inefficient market, this amounts to buying into a company that has run out of growth.
The alternative reason is that management simply reckons the shares are cheap. The snag here is that while executives have inside information, it is still notoriously difficult to second guess a market that is pretty efficient in the relative valuation of companies even if prone in the aggregate to occasional bubbles.
There is a marked lack of transparency and accountability in what is now a huge item of corporate spending and a serious misallocation of capital
Some companies conduct buyouts on a continual basis on the assumption that they will buy both cheaply and expensively, while coming out fine over the long run. Yet as any chart showing the volume of buybacks against the level of the stock market shows, most do not do that. They buy high and sell low.
Buyouts hit a peak in 2007 just in time for the stock market crash that accompanied the financial crisis. Survey evidence also casts doubt on the quality of judgments about share valuations. Deloitte found in a survey of North American chief financial officers in 2013 that 60pc thought US equities overvalued, while only 11pc thought their own stock was overvalued.
Companies are admittedly borrowing cheaply to buy their own shares, but borrowing cheaply to buy expensively is nonsense. That leaves the real, less respectable reason why companies engage in buybacks, namely to lift earnings per share by shrinking the equity.
Tim Bush, head of governance and financial analysis at Pirc, the shareholder advisory group, highlights that a majority of FTSE 100 pay schemes use earnings per share growth as a performance yardstick. In a forthcoming report he argues that the link of pay to earnings per share growth may create an incentive to undertake buybacks that destroy economic value. Similar reservations apply to the use of total shareholder return as a performance metric since the company’s share buying helps the share price.
The conflict of interest here is overwhelming. And Mr Bush points out that the choice between undertaking buybacks and paying dividends is not necessarily neutral. In the UK buybacks incur 0.5pc stamp duty and also result in investment banking and broker fees, which may be at least another 0.2pc.
The result is that impressions of real earnings growth are distorted. And perverse incentives mean there is always a temptation for companies to take risks with the balance sheet when they borrow to finance the buyback. Too often they are egged on by short-termist activist investors.
There is a marked lack of transparency and accountability in what is now a huge item of corporate spending and a serious misallocation of capital. The cost of acquiring the shares does not appear in the profit and loss account as a distribution. There is no requirement to disclose any decline in the value of shares in the accounts.
It is high time institutional investors took a firmer grip. Given the conflicts of interest and questionable logic in the buyout mania institutions should, Mr Bush rightly argues, adopt a presumption against them unless boards can make a clear, cogent and compelling case. In the UK that would mean voting against most buyback authorities. There should also be a formal requirement, I would argue, to disclose the mark to market deficit or surplus on buybacks in notes to financial statements.
Published in Dawn, Business & Finance weekly, March 7th, 2016
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