The BEIS Department of the Government has announced a review of share buy-backs. That’s where the company buys its own shares in the market, a practice that used to be illegal but is now very widespread.
Business Secretary Greg Clark said: “…there are concerns that some companies may be trying to artificially inflate executive pay by buying back their own shares. This review will examine how share buyback schemes are used and whether any action is required to prevent them from being abused.”
If a company buys back its shares, then it will increase the earnings per shares (EPS) because the same profits will be spread over fewer shares. But EPS is often an element in the calculation of performance related bonuses, e.g. in LTIPs. So effectively management can earn bonuses by simply deciding to buy back shares rather than really improving the underlying performance of the business.
Obviously cash has to be used to buy back the shares, and another concern is that this is money that should be used to develop new products, services or markets. In other words, it contributes to the lack of investment in the UK economy. In extremis companies can borrow money (i.e. gear up) to provide the funds to cover the buy-back which increases the risk profile of the company.
There is also the suspicion that some companies undertake large scale buy-backs to support their share price, often encouraged by institutional investors who wish to exit. The directors always deny this, but one can see the sub-conscious motive to “clear-up a share over-hang” that may be present. In practice, share buy-backs may benefit shareholders who are departing more than they benefit shareholders who remain.
In theory, if a company cannot find a good use for surplus cash, i.e. cannot reinvest it in the business profitably, then buying in shares where the per share intrinsic value of the company is more than the market share price should make sense. But determining what is the “intrinsic value” is not at all easy.
There are also tax issues to consider. Some investors think it’s best to retain the cash in the business because paying it out in dividends might incur more tax, and sooner, than the capital value growth that might otherwise be obtained.
You can see there are many complex issues around this topic that could fill a book, or at least a pamphlet. But here are some comments on the approach I take:
- I always vote against share buy-backs unless there are very good justifications given by management (and that’s about 1 in 20 votes in practice).
- The only general exception I make is investment companies (e.g. investment trusts) where it does make logical sense and can be used to control wide discounts.
- I prefer management to reinvest in growing the business if they have surplus cash (and as I rarely invest in no-growth businesses, you can see why the above rules are easy to apply).
If the advisors to the Government determine that share buy-backs are being undertaken for the wrong motives, what could they advise the BEIS to do about it? Reading the minds of directors about their motives for share buy-backs will not be very practical. If they simply wish to stop the abuses related to incentive schemes they could insist that all such schemes (including all share options) should be adjusted for the buy-back – they often are not at present. But would it not be simpler just to revert to the old regime and outlaw them except for investment companies? I do not recall that it created any major practical problems.
If a company’s shares consistently trade below “intrinsic value” then someone will buy them sooner or later – after all many people believe in the efficient market hypothesis and it’s probably true to a large extent – particularly with large cap companies where share buy-backs are the most common. So simply banning share buy-backs should not create significant problems.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
The obvious problem with special dividends rather than buybacks is that they may generate an immediate tax bill for non-exempt investors, plus dealing costs if they want to reinvest.
As I understand it Next has an approach which uses either dividends or buybacks depending on the share price – it might be good for the company to have to justify why buybacks are worthwhile.
Another good blog by Roger. Thank you.
There is also a good article in the FT today on this issue, see https://www.ft.com/content/e7fb2144-fbae-11e7-a492-2c9be7f3120a
I added my comment under my pseudonym cliffw8, viz.
Good stuff. Well done.
Three other points to note:
1. Buybacks tend to smooth out share prices and so the computed volatility fails to reflect the underlying volatility of the business. It is important when estimating future volatility to note this. KIDs please note. FCA please note too. FRC, SEC and IASB please note re IFRS2 valuation of share options.
2. Financial and tax incentives favour debt and hence encourage buybacks. So execs and Boards are merely responding to what Government and Regulators want them to do. Hence, we should all campaign for the removal of tax relief on debt.
3. I disagree with your Charge 2 conclusion. EPS targets set by Compensation Committees tend to be a bit soft (easy). Buybacks facilitate this fog. I estimate EPS targets should be about 2 percentage points p.a. higher due to this effect. This is part of the reason CEO bonus payouts average much more than target, and more than 50% of maximum. Similar effect on LTIPs.
The FT article is certainly a good one in covering the issues.
If you remove tax relief on debt but keep interest payments taxable that would mean double taxation. If you made the interest payments franked income like dividends it would mean that pension funds could no longer reclaim the tax, cue stories forever about the government hitting people’s pensions as we had for the abolition of ACT …
The Government have not reported on buy backs yet and Greg Clark has been exited. Perhaps Andrea Leadsom will prioritise this.