Investors should be angry at the cost of share buybacks
IF, amid much fanfare, a company announced a £1 billion investment or launched a £1 billion takeover of a rival and then, within 15 months, wrote off pretty well half the value of that investment, questions would be asked, shareholders would be furious and there would be pressure for some of the directors to quit. But if a company puts in place a share buyback and then a few months later issues a series of profit warnings leading up to a massive cut in dividends, the net result of which is for the shares pretty well to halve from their peak, no one seems to care much.
When you look at all the controversy around Rolls-Royce - though there is a lot of upset about the profit warnings, the loss of dividend and the fact that the company should have stumbled so badly - the role of the board in agreeing to a share buyback which clearly should never have taken place has not really figured. It did not used to be like this: as one fund manager was heard to reminisce last week, back in the day when Mercury Asset Management ruled the institutional fund management roost, if a board bought its own shares and then had to slash its dividend a few months later, it would have been called in, given a serious dressing down and presented with the choice of a 50% pay cut or resignation - and sometimes both.
And deservedly so - buying shares which then almost halve in value is a massive and totally unnecessary squandering of shareholder's funds. The silence on the issue these days underlines how even UK institutional share- holders are not really interested in UK equities any more in spite of the efforts by the Financial Reporting Council and the Investment Association to re-energise them.
Pension fund and insurance company holdings have been slashed - they hold fewer equities anyway and within that equity allocation they hold fewer UK stocks. Foreign investors who now hold far more shares in British companies than they once did, don't engage much. If they do any governance at all then they focus their efforts where they think they will get a more spectacular uplift if they succeed - which is in emerging markets or on the occasional scandal in the US or Europe.
Buybacks are an American idea of course - it was against the law for a company to buy its own shares in this country until the Eighties - so it is fitting that though Rolls-Royce is in the frame today, American businesses have lost even more. Associated Press last week published an analysis based on recent FactSet data with a league table of the companies which had the biggest paper losses from buy backs: IBM came top with $ 9.8 billion (£ 6.8 billion), followed by Qualcomm with $7.4 billion and American Express at $4.1 billion.
The analysis should have come with a health warning that since the oil price plunge, it is best not even to look at what's happened to the oil majors. In summary, in the past three years virtually all Standard & Poor's 500 companies got their timing wrong. The combined losses as a result for these buybacks is $126 billion, or 15% of what was paid out.
(Note the boards managed to lose this money even during a time when the American market has been buoyant.) But the bigger truth is that it is time for a re-think on share buybacks, and if that is too much to expect per- haps shareholders and analysts could at least stop and think before celebrating every time a buyback is announced.
They already understand that three-quarters of takeovers destroy value for the bidding company and they should apply the same scepticism to buybacks which after all employ the same logic - that they can make more money for shareholders from buying shares than they could from investing it properly in the expansion and development of the business. The only time a buyback creates value is if the shares which are bought are trading below their intrinsic value. Ironically on the occasions when that is the case companies either don't have the spare cash to conduct such an exercise or the board finds the prevailing conditions too scary and wants to hold onto the money.
There is of course a perverse incentive to do buybacks if you are senior management. Most of them these days are on some form of incentive scheme and more often than not part of their payout is linked to growth in earnings per share. When profits are flat, the business is going nowhere and management clearly has no idea what to do, then a buyback becomes its "get out of jail" card. Shrinking the number of shares in circulation automatically increases the earnings per share of the business as the unchanged level of profits are concentrated in fewer shares. When all else fails, it is one way to make sure those incentive bonuses keep flowing.