Investment Matters

Share buybacks

Share buybacks are being conducted on a quite unprecedented scale on the Australian market, as well as bourses overseas (the US is of note).  This week IM considers the investment merits of share buybacks.

Principles

A share buyback is conducted by a listed company when it buys its own shares, on market using capital from its own balance sheet.

Usually these shares are cancelled but can be held as ‘treasury’ shares for a period of time until they are cancelled (or in rare instances re-issued).  Either way, the earnings a company makes are shared across fewer ‘common’ shareholders, thus increasing the earnings per share (EPS).  This usually flows through to increased dividends per share (DPS) as well. 

Share buybacks act to put upwards pressure on a company’s share price because the higher EPS means the value of each share is proportionately higher (at least in theory).  Additionally, the presence of the buyback purchaser in the market decreases sell-side liquidity and puts a 'floor' on the price.

The current extent of buybacks is partly a reflection of cheap debt that has been available globally.  When debt is more expensive, there is a greater relative incentive to reduce debt (versus reducing equity via a buyback).

Some technical details

Buybacks can be active or inactive - active means that the company has recently purchased shares.  If a company has a buyback in place but is not purchasing shares, it is considered inactive.  An example of this would be where the share price was above a certain level e.g. NTA for a property REIT.

A company can buy back up to 10% of its shares each year without shareholder approval.  Larger buybacks are permitted if specific shareholder approval is obtained.

Most buybacks are on-market, whereby a broker acts for the company to buy the shares (within regulatory restrictions such as block-out times and daily price movement).

Are buybacks good for shareholders?

Buybacks are a way for a company to return cash to shareholders.  They are not a way to improve the operational performance of a company.  But the market generally loves them.

For your Investment Team, it is actually a signal of caution, in that a company is essentially saying that they don’t have anything better to do with their capital.  That is, they are better off giving funds back to shareholders, rather than using those funds to invest in organic (e.g. new equipment or capabilities), or inorganic (i.e. acquisitions) growth.

Thus, although there may be some benefit to the share price in the short term, it may signal that the company does not have good growth prospects in the medium to long-term.

It is important to consider the company’s earnings trajectory – sometimes earnings may be flatlining or worse, yet with a buyback the EPS trend can look okay.  As longer-term investors, this is a red flag for us.

Are your investments buying-back?

Three of your investments have active buybacks in place – South32, Cardno and QBE.

South32 has no debt and is generating very high cash flow.  It also has limited franking credits (because of carried-forward tax losses it only started paying franked dividends with the Oct-17 dividend).  [Generally franked dividends would be more appealing to shareholders than a buyback.]  It has been actively seeking investments and recently announced a significant one.  The fact the South32 hasn’t been more ‘acquisitory’ means that asset price expectations are still quite high, off the back of what has been a healthy recovery in the price of many commodities since the GFC.  So, given the cash flow being generated, it has made sense for the company to undertake a buyback.

Cardno also has a buyback in place.  It has no net debt. Cardno undertook the buyback because their shares were trading below their intrinsic value, and this was combined with a lack of liquidity in Cardno shares (Crescent Capital owns 47.75% of the company’s shares, and broker coverage and institutional ownership are quite low).

QBE Insurance is also undertaken a 3-year buyback, again because of the intrinsic value of the shares versus the share price.

The future of buybacks

We expect the use of buybacks to moderate somewhat.  Certainly companies with debt are facing rising interest costs, and thus reduction of debt will likely take a higher priority as funding costs inch up (90dBBSW >2% now, after being below 2% for the last 2 years, source: IRESS). 

Buybacks must be done at less than intrinsic value to add value in the longer term.  There have been some terrible blunders in the past (BHP being an example) where buybacks at elevated share prices have destroyed shareholder value.

Dexus and Mirvac have recently suspended their buyback.  This is probably due to share prices being greater than NTA, and won’t be helped by rising funding costs as noted above.

In the context of your investments, we would not be surprised to see QBE’s buyback curtailed as priority shifts to debt reduction (asset sales will likely be the main driver of this though) and capital position.