Investment Matters

Revisiting buybacks

Capital can be returned predominantly through two ways: through dividends or buybacks.

Dividends have historically been a marker of company stability and safety – although as we have discussed earlier, they are more of a function of balance sheet strength, the need for financial flexibility and the opportunities for investment a company has.  

Buybacks on the other hand represent a very different proposition.

Several companies in your portfolio currently have buybacks in place.

These include:

  • Here, There and Everywhere (HT1)
  • Cardno (CDD)
  • Viva Energy (VEA)
  • GDI Group (GDI)
  • Total Return Fund (TOT)
  • 360 Capital (TGP)


The question therefore is, why would a company be returning capital in the current environment?

And what do buybacks tell us about a company?

The capital allocation decision

Why do companies return their capital in the form of buybacks rather than dividends?

This is a particularly pertinent question in Australia, where dividends have a tax-advantaged status due to franking credits.

Much like dividends, the decision to pay out capital depends on several factors including:

  • Balance sheet health
  • The availability of opportunities for investment (that meet required return hurdles)
  • How stable a company’s earnings or cash flows are (those that are less stable need to keep more cash aside for a rainy day).

With respect to buybacks, we add two other considerations:

  • Share price – how cheap it is relative to its fundamental value
  • Franking credit balances

What is therefore unique about buybacks is that they are a way for companies to return capital to shareholders, while also expressing a view on how cheap their current share price is.

However, this assessment is not always correct. Furthermore, a company does not always have a buyback in place because it deems its shares are undervalued.

Better to give than to receive

How does a company buying back its shares benefit existing shareholders?

While some will focus on metrics like increases in earnings per share (the theory being that with fewer shares outstanding and the same earnings, earnings per share are higher) these measures often tell us little about whether or not value has been created.

A better way of viewing the value created by buybacks is by viewing the value of a business as the future cash flows it can generate, discounted an appropriate rate to reflect the risk and opportunity cost of investing.

A simple example follows:

If a company is expected to generate $100 m of cash flows in the future and has 100 million shares outstanding, it is worth $1 per share.

If it can buy back 20 million of these shares for $0.50 per share it will spend $10m in cash.

This will leave $90m in cash flows, to be distributed amongst 80 million shares – which will increase the value of existing shares to $1.125 or a 12.5% return.

It is also worth noting that in the short term, the act of a company buying back its shares provides support to its share price.

Buybacks therefore also provide an attribute by which we can screen the market for companies that are cheap.

A reflection of governance

In years gone by, we have examples of behaviour that represented “empire building” or “growth for growth’s sake”, that is, companies pursuing investments that did not add value to shareholders or earn an acceptable rate of return.

A recent example that comes to mind is BHP’s purchase of shale oil assets – which paid US$40 bn for (including investments) during an oil boom only to later divest in 2018 for $US10.8.

The decision to return capital to shareholders in place of pursuing value destroying growth is therefore a sign of good management and stewardship of capital.

An example in your portfolio

GDI Group (Property sub-portfolio) is an example of a company that has growth opportunities but is buying back its shares because they trade far below their fundamental value.

The book value of its assets as at the 30th of June was $1.30 – yet it currently trades at levels around $1.00 – a significant discount.

Summary

Several companies in your portfolio currently have active buybacks in place.

Buybacks are an alternative way of returning capital to shareholders and can be implemented for several reasons.

When they are implemented for the right reasons, they reflect good governance, strong stewardship of capital and in many cases, an undervalued share price.