Out of fash­ion

Buy­ing back shares shows that the com­pany lacks in­no­va­tive think­ing

Finweek English Edition - - Companies & markets - VIC DE KLERK

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.

SHARE BUY­BACKS... TO BUY OR NOT TO BUY?

Source: I-Net Bridge

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