Advisory Intelligence: Why small caps should rethink joining the buyback boom

Sep 07, 2018
Nasdaq’s Sean Hanley outlines why small caps may wish to think twice before participating in the buyback boom

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US public companies are set to spend as much as $2.5 trillion on share buybacks, dividend payouts and M&A activity this year, according to a report from UBS.

This trend is largely driven by the US Tax Cuts and Jobs Act, which gave many US public companies a short-term cash injection due to the estimated $1.5 trillion tax break. Share buybacks can have a positive influence on a company’s earnings per share and stock price and are therefore being touted as a way to deliver value back to shareholders by Apple, Cisco, PepsiCo, Well Fargo, Alphabet and many more companies.

But Sean Hanley, Nasdaq’s strategic capital intelligence senior analyst in Chicago, cautions that small caps may wish to think carefully before following the buyback trend.

‘There can be a groupthink or public pressure for small cap management, where they feel like they have to keep up with larger peers and incorporate buybacks,’ Hanley says. ‘Small caps ought to remember that and they shouldn’t get too distracted about the buzz around buybacks, but instead be mindful about how they’re allocating spending and focusing on long-term growth.’

A lot of small cap companies are faced with the challenge of reducing volatility in their stock. Due to the stock price and cap size, small caps can attract hedge funds and quant funds more than long-term institutional investors. But Hanley says that being smart about capital allocation now could positively influence the class of investor that small caps can attract.

‘Institutional investors could choose a less volatile company to invest in if they have the choice of two peer companies,’ Hanley says. ‘Small caps should understand how their capital allocation strategy is faring relative to their peers. In my view, small caps are likely looking to shore up their leverage base and debt base to explore long-term projects – growing assets, talent, building out new facilities etc. – and not get drawn into the short-term allure of a buyback.’

However, Hanley acknowledges that circumstances are different for every company and that the cheap price of debt could be attractive to some. A number of small and mid-caps he works with have taken on short-term debt to pursue M&A activity, for instance. ‘It’s a strong sign of management’s confidence to be able to take out debt and pay it back,’ he says.

For small caps companies considering taking on more debt, Hanley cautions that we could be coming to the end of a 10-year bull run in the markets. ‘Shareholders have had a great run this last decade, but now they’re getting a bit more focused in case the market does correct,’ Hanley says. ‘If we see a pullback, that free cash won’t be there but the debt will be and companies will be on the hook for it.’

So if small cap balance sheets are coming under greater scrutiny from investors, what should IR teams be focused on? ‘Over the last 10 years, IR teams have been very focused on total shareholder returns and looking at their performance versus the indexes. We encourage also looking at what else could be under the hood. How have you achieved these amazing returns? Have you taken on a lot of debt? Ultimately it’s about understanding your risk/reward profile and that’s why investors are paying more attention to debt loads.’

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