Out of fashion
Buying back shares shows that the company lacks innovative thinking
THE PRACTICE – rather fad – among some companies of buying back their own shares on a large scale is losing popularity. It doesn’t create wealth and investors have long since stopped being impressed by apparent increases in earnings per share as a result of such buybacks.
This topic appears regularly in the financial press in the United States. The price performance of BHP Billiton – the company that’s been buying back most shares on the JSE and the London and Australian stock exchanges – confirms that statement.
The recent announcement by BHP Billiton that it was planning to buy back its own shares to the value of as much as US$10bn (around R72bn) did little for its share price. The daily reporting on Anglo American and BHP Billiton on the JSE news service (Sens) also hardly attracts attention any longer.
Investors want action. Last week’s rumours that BHP Billiton – perhaps with Rio Tinto, or perhaps on its own – was going to make an attempt to take over Alcoa, the world’s largest aluminium producer with a market value of $30bn (R217bn) at a premium of $40 (R290), was immediately welcomed by investors and the share price jumped much more than with the earlier buyback of shares.
Writing in the New York Times recently, Ben Stein gave three important reasons why the practice of buying back shares – popularised by Wall Street about five years ago as the new miracle for cooking up growth in company profits – is losing favour among investors.
First, there’s the problem of the current low interest rates that make it “profitable” for companies to buy their own shares back at earnings yields that don’t really stimulate any investor’s appetite. The principle of buying back shares is that the company can bring about an increase in its earnings per share if it buys back its own shares at an earnings yield that’s higher than the interest that it earns on its own surplus capital.
Currently, interests are as low as 5%, or even less, which means that the company can buy its own shares back at a price:earnings ratio of as much as 20. Conversely, the company is satisfied with a return of 5% on its new business.
However, investors want a return of between 10% and 12%, Stein says, and therefore they’re definitely avoiding companies where the management is satisfied with a return of 5%. That’s a certain sign that the company has reached maturity and can make no better use of its surplus money than to buy back its own shares.
For the management, that’s also a safe way of investing money. Why take risks elsewhere if the buying back of shares guarantees an increase in profit?
Second, Stein points out that the management and ordinary shareholders benefit differently from the small improvement in earnings per share that’s achieved mathematically from the buying back of shares. Often new options are granted to management on the strength of the increase in earnings per share – and then they earn an easy profit, though they haven’t created any wealth themselves.
The extremely critical Bob Djurdjevic, president of Annex Research, said recently: “IBM has already spent $73bn on share repurchases without creating a single product or a single job. It’s a signal they don’t have the imagination or creativity to employ the capital more productively.” Harsh words – but that’s probably the main reason why IBM’s share price has just been plodding along over the past decade.
Last year, a couple of the biggest US companies spent more than $325bn (that’s more than SA’s whole gross domestic product) on buying back their own shares. That’s considerably more than the modest $200bn of the previous year.
But that’s not the end of it. According to Stein, the cash resources of the S&P 500 companies amounted to as much as $2,6 trillion at end-2006. That’s nearly 10 times more than was spent on buying back shares over the past year.
In SA it’s the large mining companies, with Anglo and now especially BHP Billiton in the lead, that are buying back their own shares on a large and ongoing scale.
It would be unfair to compare the performances of the two companies’ share prices only on the basis of their management’s eagerness to buy back their own shares. However, sometimes that does tell us something. It’s generally known that BHP Billiton has kept itself fairly occupied with share buybacks over the past three years. There was once even a special buyback of the 60% of its shares listed on the Australian stock exchange, as that held certain tax benefits for its Australian investors.
Naspers, Finweek’s parent company, has been rather busy with various plans and expansions recently, especially since it sold Open TV. We understand that the buying back of its own shares seldom if ever made it to the agenda at any of its board meetings over the past four years.
To compare the price performance of these two shares over the past four years we had to use a logarithmic scale, otherwise we would have needed three pages.
It might be a good idea to close with a quote from Djurdjevic, referring to one of his favourite companies: “The company has largely abstained from the stock buyback craze, preferring to grow its business and its market cap the old-fashioned way – by making money rather than giving it away.”
That’s very applicable to many SA companies.