In part one of this article series, Edison Group CEO Fraser Thorne discussed the recent rise in share buybacks, what’s driving the activity and whether buybacks are better for management or investors. In part two he discusses when share buybacks are more effective and outlines the risks associated with leveraging debt for them.
Share buybacks are most effective when valuations are at their lowest
Company executives can often be bad judges of value. The only year in the past 14 when US companies spent less on buybacks than dividends was 2009 in the immediate aftermath of the last recession and when share prices were at rock bottom. Fast forward a decade and companies justify buybacks in terms of discipline and confidence. But nine years into the US equity bull run, companies are buying back shares when long-term valuations have rarely been higher: the Dow Jones Industrial Average has tripled in value since 2009. Â
Yet it is surely during a recession when a company with spare cash should consider buying back its own shares, partly to protect the share price and also because its own shares are likely to be far cheaper. Few company executives with more cash on account than the company needs, and nothing better to invest in, ask themselves whether buying their own stock is a good investment.
The time when companies have plenty of spare cash tends to be when business is good and shares are fully valued. It is also hard for executives to argue that their shares are overpriced but maybe longer-term strategies could themselves lead to the required outcome of achieving a valuation premium to the peer group.
Share buybacks can backfire and may reduce real opportunities for the company. Instead of using spare cash for growth, the funds are channeled into propping up the EPS, which can be damaging to the overall market cap. To put this into context, in the past 20 years IBM has spent $162 bn on share buybacks of more than half of its shares. For investors that did not sell, the company now has a market cap of $154 bn. What kind of company might IBM be today had it spent even some of that money on R&D instead?
Leveraging debt for share buybacks
Leveraging debt for share buybacks is like dropping a brick on a rubber band – eventually it has to spring back and can hit you in the face. The most recent surge in share buybacks comes as many companies have piled up cheap debt to fund payouts to shareholders. Prompted by the low-interest-rate environment of the last decade, companies have borrowed to fund share buybacks and boost EPS. Debt may be cheap – and tax-deductible – but at some point interest rates must and, surely will, rise. Equity, however, as a source of capital for business, is evergreen. It does not need to be repaid. In a credit crunch or downturn, dividends can be cut to save cash and fresh stock issued.
Yet the popularity of buybacks has changed things. Before the 2008 financial crisis, measures of indebtedness fell. It is true that overall debt levels were rising, but asset values were also much higher. In April 2017 the International Monetary Fund calculated that $7.8 tn had been added to the liabilities of US companies since 2010 while median net debt of S&P 500 companies was close to a record high of 1.5 times earnings. Contemplating Federal Reserve plans to raise interest rates, the IMF last year warned that businesses representing a fifth of corporate assets could struggle to meet higher interest costs.Â
Companies issuing shares to pay off debts rarely do well, so why do markets believe it is different to borrow to buy back shares? Many now believe buybacks have become too widely adopted by companies as part of ‘a creative valuation strategy’ that is organized by those closest to the companies and often go unchallenged by regular investors. There is a culture of acceptability that can be difficult to question as few investors want to challenge management in their drive to improve shareholder returns.
Rather than leveraging debt to fund share buyback programs, why not invest in R&D, staff, partners, customers and other factors that will help influence the future health of the company? R&D spending at many listed companies remains below pre-2008 levels. This may sound easier said than done but if companies are awash with cash they want to put to use then surely one way to do this is to invest in growth? If a company is worried about its valuation, surely the way to rectify this is to invest in growth and more R&D?
Share buyback programs ultimately reduce liquidity in shares, and it is the employees who often benefit over investors, making companies vulnerable to activist investors and rising interest rates. Is it any wonder that investors look increasingly off the market for growth when public markets are stagnating and the number of listed companies in the US has fallen by 50 percent since 1997? There must be better ways to ensure shareholder value.
Fraser Thorne is chief executive officer of Edison Group.Â
