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Share buy-backs
Blowing the whistle on buybacks and
value destruction
Lack of transparency over huge
item of corporate spending
“Markets
Insight
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© EPA
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[march
1, 2016]
by:
John Plender
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 the volumes were smaller,
but by no means 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 clearly undervalued,
which implies an implausibly 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.
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 60 per cent thought US equities overvalued, while only 11 per
cent thought their own stock was overvalued. Companies are admittedly
borrowing cheaply to buy their own shares, but borrowing cheaply to
buy expensively is a nonsense.
That leaves the real, less respectable reason why companies engage in
buybacks, namely to boost 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 boosts the share price.
The conflict of interest here is overwhelming. And Mr Bush points out
that, whatever finance theory may say, the choice between undertaking
buybacks and paying dividends is not necessarily neutral. In the UK
buybacks incur 0.5 per cent stamp duty and also result in investment
banking and broker fees which may be at least another 0.2 per cent.
The result is that impressions of real earnings growth are distorted.
And perverse incentives mean that 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.
john.plender@ft.com
Copyright The Financial Times Limited 2016. |
