Bigger slice of the pie
DIVIDENDS are the best-known way for companies to reward loyal shareholders, but many investors overlook another method known as the share buyback.
It is time to wake up to the benefits, because share buybacks look set to hit a record high this year.
FTSE 100 companies have already announced £33billion of buybacks, putting them on course to smash through the 2018 total of £34.9billion.
This is on top of a forecast £81.2billion worth of dividends, according to research from investment platform AJ Bell.
A share buyback is when a company uses spare cash to buy its own shares, often after management has decided they are undervalued, said Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.
Individual investors still own the same number of shares, but because there are fewer shares in total, the value of their holdings should rise, all else being equal.
“Effectively, the same earnings pie is cut into fewer slices. Each slice gives investors a greater share of company earnings and dividends,” she said.
There are dangers, though. One risk is that the shares fall afterwards, which means the company has got a poor return on its money, Streeter said.
“Another is that it slashes the amount of
cash the company has in reserve for an emergency or to invest in the business, which could slow its future growth prospects,’’ she added.
Russ Mould,aj Bell’s investment director, said investors should ask whether the cash would be better spent on research, product development, capital investment and marketing.
He said share buybacks are less reliable than dividends as they can be cancelled or halted just as quickly as they are launched.
While there is uproar when dividends are cut, which deters management from doing this unless it has no choice, there are fewer complaints when share buybacks are cancelled, making them easier to drop.
During the pandemic in 2020, FTSE 100 firms scrapped buybacks totalling £10.3billion, but it was the £26.5billion in dividend suspensions that caused all the controversy.
History shows that companies also make poor investors, as too often they buy their own shares during bull markets when they are expensive, rather than bear markets when much cheaper. So they typically buy high rather than low.
Banks such as Lloyds and Natwest, oil giant Shell, and Diageo, British American Tobacco and Unilever are running among the largest FTSE 100 buyback schemes, and all are offering generous dividend programmes as well.
Buybacks can be a positive sign but do not guarantee strong share price performance, Mould said: “Some FTSE 100 stock prices have not particularly responded to buybacks, including Shell, BP, Glaxosmithkline and Vodafone.”
He added another danger is that management uses buybacks to manipulate the share price, in a bid to trigger management bonuses or stock options.
Provided the company has enough funds to run its business properly, and the shares are trading at a discount to the underlying value, buybacks can work. “Although be wary if management is taking on debt to do so,” Mould added.
Investors pay income tax on dividends, but capital gains tax on buybacks, assuming they push up the company share price.
If you invest via a tax-free stocks and shares Isa, there should be no tax to pay on either.