Are share buy-backs a good thing?
Share buy-back programmes tend to have a poor reputation among private investors. If a company has surplus cash to disperse, many prefer to see it paid out in a dividend. So news that Warren Buffett's Berkshire Hathaway group is buying back shares in spades sends confusing messages. The Sage of Omaha's words of wisdom are followed by private and professional investors alike, and in the past he's been less than complimentary about buy-backs.
However, last week Berkshire Hathaway boosted its one-year-old buy-back programme with a $1.2bn purchase from a single long-term investor, and doubled the premium over book value at which repurchases can be made from 10% to 20%. That's expected to foreshadow more repurchases, though unlikely to dent Berkshire Hathaway's $48bn cash pile.
There is no shortage of companies on the FTSE 100 (LSE: UKX) buying their own shares at the moment. Companies such as British American Tobacco (LSE: BATS), Imperial Tobacco (LSE: IMT), GlaxoSmithKline (LSE: GSK) and Wm Morrison (LSE: MRW) announce purchases practically daily.
So just what are the pros and cons of share buybacks, and why is it such a common strategy these days?
The traditional argument is that share buy-backs are a tax-efficient means of returning surplus capital to shareholders. It should boost the share price and so produce a capital gain rather than income, which is often taxed at a higher rate. By reducing the number of shares in issue, it also increases earnings per share (EPS), which supports dividend growth in the long run.
Critics say it represents an unadventurous use of cash, and is frequently motivated by management's desire to increase the share price and/or EPS on which bonuses and long-term incentive programmes are based. But perhaps the most damning indictment is that companies frequently time it badly, buying shares at a high only to see the price decline later.
I see four reasons why buy-backs are so prevalent these days:
- Companies have surplus cash but, with low confidence, are nervous about investing in new projects or acquisitions;
- Valuations are historically low, so companies are less fearful of buying their own shares at the wrong price;
- Dividend yields are high, and companies are reluctant to commit to possibly unsustainable dividend increases;
- Interest rates are low, so the interest lost on cash surpluses or the cost of increased debt to fund buy-backs is relatively low.
It's no surprise to see the tobacco companies, BATS and Imperial, among those with big buy-back programmes. They are prodigious cash generators but in a mature and highly consolidated industry -- arguably ex-growth -- so have few opportunities for acquisitions and limited capital expenditure, but would probably not want to push their dividend yields over 5%.
It's more surprising to see Wm Morrison on the list. Supermarkets are still investing heavily to fight intense competition, and Morrisons is playing catch-up with the sector in online sales and convenience stores. But in March 2011 the company committed itself to a two-year programme to buy back £1bn of shares. With its gearing below the sector average, the plan is designed to boost shareholders' returns.
Like the tobacco companies, GSK generates vast amounts of cash, but it would have more opportunities to spend it through acquisitions. Generally the pharmaceutical sector is investing, especially in biotech, to secure its long-term future as blockbuster drugs go off-patent. But in 2011, GSK returned all its free cash flow to shareholders through £3.4bn of dividends and £2.2bn of share purchases, and is targeting more buy-backs this year.
Rival AstraZeneca (LSE: AZN) changed tack in October when new CEO Pascal Soriot took over. He immediately put a stop to its £4.2bn buy-back programme, of which roughly half had already been spent. That looks a good sign that the company will invest, by acquisitions or through R&D, to address its impending patent cliff.
But the market has yet to see what Mr Soriot will do. It may be unimaginative to return cash, but investors like share buy-backs if they stop management making silly acquisitions.
That thinking may be one of the factors behind Mr Buffett's share repurchases. He sees no attractive opportunities to spend Berkshire Hathaway's massive cash pile, and is unwilling to make acquisitions for the sake of it.
One investment he did think worthwhile is right here in Britain. But only one. The Sage of Omaha has invested in just one British company, with large purchases over several years including this year. To find out its identity, you can download this free Motley Fool report: "The One UK Share Warren Buffett Loves". Just click here.
> Tony owns shares in BATS, Imperial and GSK but no other shares mentioned in this article.