There is nothing that divides the investment community more than share buybacks.
However, despite the wealth of information, and studies on the benefits/drawbacks of repurchases, a solid universal conclusion has remained elusive.
Opposition to buybacks
In the UK, buybacks are generally considered a waste of shareholder funds. British investors prefer their investments to pay hefty dividends. Many reasons are citied against the use of buybacks:
- The stock market is supposed to be a long-term compounding machine. Replace dividends with buybacks and compounding takes a hit.
- As an executive with a compensation plan linked to share performance, if you buyback and bump the share price up, your options are suddenly worth more.
- Buybacks destroy shareholder funds.
- They offer a disproportionate benefit to employees via share options.
- They represent “the gradual expropriation of shareholder assets” and the regular misallocation of capital.
- They enrich the investment banks
Surprisingly, the British hold a negative view against buybacks despite their tax advantages — the UK has one of the highest income tax rates in the world.
Dividends are subject to double taxation on both corporate profits and at the investor’s marginal rate. In comparison, buybacks have tax advantages.
If debt is used to buy back stock, interest payments are tax deductible, reducing the tax bill. Further, the investor has no additional tax to pay. A back-of-the-envelope sum; $100 of corporate profit taxed at 35% = $65 paid out to investors as a dividend, is then taxed at a further 30%, reducing the profit paid out to $45.5 — a near 55% reduction.
Do buybacks really destroy value?
The main argument against the use of buybacks, as mentioned above, is the destruction of shareholder value. But is this really the case?
The Real Effects of Share Repurchases, was a study conducted at the University of Illinois last year. The study attempted to study the consequences of repurchases motivated by earnings management and whether or not the buyback destroyed shareholder value.
The study quotes several previous papers, which found that; repurchases can be used to hit earnings targets; cash-rich companies tend to generate greater abnormal announcement returns when starting new repurchase programs; managements use repurchases to reverse the dilutive effect of stock options; CEOs with shorter pay duration are more likely to repurchase shares following good stock performance.
However, The Real Effects of Share Repurchases study finds that EPS-motivated repurchases are not detrimental to ?rm performance. What’s more, it was found that while companies are willing to trade-o? employment and investment for stock repurchases, this trade-o? does not appear to be detrimental to ?rm performance and shareholder value.
“… Since EPS-induced repurchases do not decrease stock prices or ?rm performance, it is likely that the investment projects that get cut because of repurchases are not positive NPV. Another possibility is that the investments that get cut are positive NPV, but ?rms derive other bene?ts from meeting analyst forecasts which compensate for the loss of positive NPV projects…”
In contrast to the study above, a study published by Bloomberg, conducted pre-2008/2009 found that amid record levels of share repurchases, most companies were unable to increase shareholder value
The following is an excerpt from the report prepared by Standard & Poor’s Equity Research:
“…During the six completed quarters ended June 30, 2007, 423 companies in the S&P 500 reported share repurchases, removing nearly 20 billion shares from the market…While these corporate actions appear to have been intended to be shareholder-friendly, there may have been more appropriate uses for the cash…”
“…Conventional wisdom holds that (1) stock prices go up as a result of buybacks, (2) more buybacks are better than fewer buybacks, and (3) announced share buybacks actually reduce the number of outstanding shares significantly…Based on a study of buybacks conducted by S&P’s Equity Research Services of the 18 months ended June 30, 2007, we believe that all three points were unsupported by the data during that period…most companies have been too enthusiastic with their stock-buyback programs and have not increased shareholder value…”
The ratings agency conducted a further study over a period of three years ended June 30th 2010, which was reviewed by Institutional Investor. During the post-crisis period, 353 companies within the S&P 500 brought back stock and issued a dividend, 95 just repurchased stock, 39 just paid dividends and only 13 did neither.
The results showed that companies which undertook buybacks and nothing else during the period, generated an average unweighted total return of -10.5%. Companies that only issued dividends achieved a total return of -12.7% and those that brought back stock and issued a dividend came out worst, returning a disappointing -21.3%.
Interestingly, companies engaging in “high-frequency” buybacks, buying back stock during nine or more of the 36 quarters studied, achieved a total return of -4.4%.
This study appears to show that buybacks do actually increase shareholder value. The main difference between the three studies above; time.
The University of Illinois study studied repurchase data over the period 1988 to 2010. The study conducted before the fincinal crisis only looked at several months of data, while the one after took data over several years.
These results appear to show that over long-term time frame, buybacks create value for investors. While, over the short-term, during a period of market euphoria, buybacks do not improve shareholder value.
To settle the debate
With the benefits of buybacks under almost continual debate, Institutional Investor has set out to settle the argument once and for all.
Institutional Investor introduced a Corporate Buyback Scorecard during 2012, a study compiled by Fortuna Advisors, a New York City-based consultancy, which ranks the biggest spenders on buybacks among members of the S&P 500 (INDEXSP:.INX) based on the returns their repurchases generated.
The companies are ranked according to their return on investment; buyback ROI measures the overall rate of return on buybacks, based on the internal rate of return of the cash flows associated with them. In addition, buyback strategy tracks the performance of the underlying stock in terms of annualized total shareholder return. The buybacks effectiveness is simply the difference between the two figures, determined as a compounded return. The most recent study assessed data from March 31st 2012 through March 31st 2014.
Over the period studied, across 270 companies, the mean buyback size was $3.35 billion, 8.6% of the mean market capitalization for the study. The average buyback ROI was 27.5% and buybacks strategy was 22.3% giving an average buyback effectiveness of 4.3%.
Topping the list, achieving a buyback ROI of 157% by spending $1.15 billion to acquire 6.7% of outstanding shares, Keurig Green Mountain Inc (NASDAQ:GMCR). The list’s second best performer, Gilead Sciences, Inc. (NASDAQ:GILD) with a buyback ROI of 90.4%. Southwest Airlines Co (NYSE:LUV) achieved an ROI of 84.1% coming third and Yahoo! Inc. (NASDAQ:YHOO)’s buyback, which absorbed 16.3% of the company’s outstanding shares, achieved an ROI of 78.6%.
Near the bottom of the list sits two serial buy backers,International Business Machines Corp. (NYSE:IBM) and Philip Morris International Inc. (NYSE:PM), which brought back stock equal to 15.5% and 29.5% of their market caps respectively during the period studied; both achieved negative buyback ROIs. CenturyLink, Inc. (NYSE:CTL) and Teradata Corporation (NYSE:TDC) came in stone cold last place with buyback ROI’s of -13.4% and -22.8% respectively.
All in all, it would appear that buybacks do indeed have their benefits. Over