Time to encourage share buybacks
There is a huge gap between the use of share buybacks as a means of returning surplus cash to shareholders in the US and in Malaysia and Singapore. Why is this so? What are the merits of share buybacks and should they be encouraged?
The US stock market was the best performing among major markets last year — the Standard & Poor’s 500 gained 28.9%. In fact, US stocks are in the longest bull market in recorded history, with the S&P 500 almost tripling in value over the past decade. These facts have been widely covered by the mainstream media. What is perhaps less well-publicised is the outsized role of company share buybacks in this long-running bull market.
Share buybacks were legalised in 1982 as part of the Reagan administration’s deregulation push. But it was only in the past decade that Corporate America truly embraced this practice.
Share buybacks, in absolute dollar value, have risen significantly since the end of the global financial crisis (see Chart 1). The amount spent on share buybacks by S&P 500 companies totalled US$5.47 trillion between 2010 and 2019, almost 4.4 times the total spent in the previous decade (2000 to 2009), which came up to just US$1.25 trillion.
As we have pointed out before, the stock market is a market for stocks. In other words, prices are determined by demand-supply dynamics, the same way as in markets for any other goods and services.
Not only are share buybacks a source of demand, they also reduce the long-term supply by taking the repurchased shares out of circulation. For any other buyers (not the company), the supply side of the equation remains unchanged. This itself gives buybacks an outsized role in the market.
Added to the backdrop of shrinking overall trade volumes (see Chart 2), the role of share buybacks in the US market becomes even larger — share buybacks as a percentage of the S&P 500 index value traded averaged 6.5% in the 2010s, compared with just 1.1% in the preceding decade — and they quite likely have influenced overall price movements.
After all, share buybacks send a signal to the market that management is confident of the company’s prospects and that its shares are undervalued. Historically, we do see a strong positive correlation between share buybacks and the US market rally (see Chart 3).
In fact, share buybacks have been the largest source of demand, by far, for US stocks, especially in the past few years. They have more than offset the net outflow from equity funds (mutual funds and exchange-traded funds combined), ensuring net money inflow into the stock market (see Chart 4). Their steadying presence likely contributed to the lower-than-historical market volatility recorded in recent years.
The rise of share buybacks in the US is quite divergent from what we observe in the Malaysian and Singapore markets, where the value of buybacks is very small by comparison.
We sense that share buybacks carry a more negative perception — in terms of governance and conflict of interests — in this part of the world and are often seen as a potential for market price manipulation. These worries may have some justification in certain cases, for instance, if management uses share buybacks to artificially support prices for its own benefit or to cash out a major shareholder.
On balance, though, we believe that the positives of share buybacks outweigh the negatives. In other words, just because there is a chance for abuse does not mean that we should not do it.
There is nothing wrong with companies returning excess cash to shareholders. They should, especially if the cash is sitting idle on the balance sheet with no visibility on its imminent utilisation.
Most companies currently return cash through dividends. Share buybacks are a legitimate alternative — and are particularly favoured by US companies for a good reason.
Because buybacks are widely accepted as “discretionary”, investors do not react unfavourably when the buyback amount is reduced, unlike if dividends were cut. That allows management greater flexibility, in terms of managing its cash flows.
Hence, while total dividends paid by S&P 500 companies have been rising steadily — from US$141 billion in 2000 to US$503
billion in 2019 — the amount spent on share buybacks has risen by a lot more over the same period.
The value of shares repurchased averaged about 1.6 times total dividends paid in the 2010s, up from 0.6 times between 2000 and 2009. This was due to a confluence of events in the last decade that boosted company cash and therefore, was conducive to larger distributions — but which may or may not be sustainable in the long run.
In the aftermath of the 2008 recession, there is slack in the economy, which means less need for investments and expansions. Technological advancements also translate into less capital intensity, whereby increased assets utilisation and efficiency can produce higher output without requiring higher capex.
The corporate tax cuts in 2018 too generated huge windfalls and stronger cash flows for companies. MNCs are able to repatriate cash previously parked overseas at lower tax rates.
Share buybacks are, by and large, also positive from the shareholder’s perspective. Since repurchased shares reduce the number of shares outstanding, buybacks result in higher earnings per share (even if earnings are unchanged). This, then, translates into a higher share price — and capital gains for shareholders.
Thus, share buybacks are akin to the shareholders’ reinvesting in the company, if cash was to be returned by way of dividends — but without the hassle of actually having to do so.
If shareholders wish to reinvest in other stocks or consume the cash, they can easily realise the gain by selling a fraction of their holdings at the higher price. In Malaysia and Singapore, neither capital gain nor dividend income is taxable.
It is quite clear that share buybacks have many benefits. Why, then, are they not more popular in Malaysia and Singapore, where many companies are sitting on cash? Of the 894 companies listed on Bursa Malaysia (excluding financials and real estate investment trusts), 407, or about 46%, are currently in a net-cash position. In Singapore, the number is 41%, or 274 of the 675 listed companies.
Could it be due to the negative connotation (real or perceived) that such moves might be seen as an attempt to manipulate share prices? Are managements worried about possible legal ramifications and liability?
Companies undertaking buybacks are not exempt from insider trading rules. And the company is the ultimate insider — it will at any point in time always have more information than the public. So, does it mean the act of buying back its own shares is insider dealing?
I suppose the test is whether the company possesses information that ought to be released to the public at the time it buys back its own shares. And I suppose the company decides by taking into consideration issues such as materiality, certainty or probability of outcome, sensitivity to its business and so on. But the decision — on whether to make such information public — is one the board and management would have to make independent of their action to buy back shares.
In other words, it would seem to me that, for the law to approve of share buybacks, and knowing the company will always have more information about itself than the public at any moment in time, the interpretation of insider dealing when it comes to share buybacks is not as strict as when the shares are bought by purchasers other than the company.
The rules and limitations for share buybacks are, in fact, quite similar in the US, Malaysia and Singapore, especially with respect to insider trading while in possession of material non-public information. Evidently, though, US companies are much more comfortable undertaking large buyback programmes.
Apple, for example, spent over US$66 billion on share buybacks for the trailing 12-month period to September 2019. For the first nine months of last year, the value of Apple’s share buybacks averaged 5.6% of total value traded on the market, up from about 4.7% in 2018.
Chart 5 tracks the outperformance of Apple’s share price over the S&P 500 against the value of repurchased shares over the last few years. It suggests a strong positive correlation.
Apple’s management, no doubt, must have all the information about the company’s upcoming products and services, much more than the public. The fact is that no question was raised on the issue of share manipulation or abuse — not from the regulators and not from any major financial institution or mainstream media. It is simply accepted as a means of rewarding shareholders.
For all of the reasons above, perhaps Malaysian and Singapore regulators should be more actively supportive of wider share buybacks. If there are worries about abuse, the buyback decision can be given to an independent committee of the board.
Alternatively, the company can establish a trading plan — with predetermined price range, volume, value, period and so on — to be executed by a broker. The plan can be announced to the public. This way, the company can distance itself from questions of insider trading, and the buyback programme can continue even during blackout periods or when it subsequently possesses material information that can affect market prices. The company will lose discretion over the buying back of its shares but gains certainty.
Current rules require that any buyback be immediately disclosed to the public. Large buybacks telegraph management’s belief in the company’s future and undervaluation of its shares. The action — if not the reasons in so many words — would surely help boost investor confidence and rejuvenate interest in the stock and the broader market.
The Global Portfolio continued to perform well, gaining 2% for the week ended Jan 16. Homebuilder Lennar Corp has done very well since our acquisition two weeks back, up 9% for the week and 7.9% from our cost.
Last week’s gains lifted total portfolio returns to 23.1% since inception. The portfolio continues to outperform the benchmark MSCI World Net Return index, which is up 18.3% over the same period.
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