The
following Pacifica Partners article was also published in the Financial Post To
an income oriented investor,
today’s low interest rates are proving to be a challenge. The “easy
money” policies of most central banks have driven interest rates “lower
for longer” and created a demand for income oriented equities. The
boards of many publicly traded companies have responded to the demand
by promising to return cash back to shareholders through increased
dividends and stock buybacks.
While dividends are the most well-known method of returning cash to
shareholders stock buybacks are becoming increasingly important because
of the sheer dollar volume of these transactions. A stock buyback is
when companies purchase their own shares in the open market. Where the
cash for these purchases comes from is important: it is either borrowed
or generated from operating cash flow. For companies with strong credit
ratings, borrowing to fund share buybacks can make financial sense.
There
has been considerable debate as
to whether or not the benefits of share buybacks are better for
shareholders than simply rewarding them with direct cash payments
through increased dividends. In short, “What is the best bang for the
buck?” Some investors prefer the direct cash payments from dividends
over buybacks.
Supporters
of buybacks over dividends
believe that buybacks are in fact valuable because they reduce the
number of shares outstanding. This makes the remaining shares become
more valuable because they now represent a greater percentage ownership
in the company. However, this is not always the case. From the chart,
we can see that large stock buybacks do not always correlate to great
stock performance. For example, Safeway bought back over 40% of its
shares outstanding in the ten year period from 2003 to 2012 but its
stock price actually declined. The buyback history of the other
companies shows that price performance and size of the buyback do not
necessarily correlate well. This means that other factors such as
profitability and industry conditions that impact stock performance can
offset even substantial stock buybacks.
Click Here to view a larger version of
this diagram
In
short, not all buybacks are the
same. Some investors complain that buyback decisions are sometimes
driven by companies whose executive teams have their compensation tied
to changes in earnings per share (EPS). For example, some studies have
found that a company that needs to meet a certain EPS target often turn
to buybacks to hit its earnings target. Other times, companies buy back
their shares to offset the shares that they issue to key employees as
part of their compensation.
Too
often, great excitement is
generated by an announced buyback. What investors need to remember is
that an announcement is an intention – not a promise – to buy back
stock. According to data from Standard & Poor’s, of the 317
companies that repurchased shares in Q4 2012 only 98 actually reduced
their share count while 203 of these buyers saw their share counts
actually rise. This means that the companies were using the repurchases
to offset shares issued; that is, buying shares with one hand and
issuing more with the other.
Another
weakness often pointed out in
the buyback data is that too often companies buy back more shares near
peaks in their share price rather than when the shares are at low
points. This means that the buyback companies are not getting a “good
bang for the buck.”
One
of the strongest examples of
buybacks that largely reflect money not well spent was in 2007 – just
prior to the financial crisis. That year, U.S. companies set a record
for buybacks as companies spent $589.1-billion. It seems that
corporations and their boards that authorize buybacks tend to spend
more on buybacks during booms and are reluctant or unable to do
buybacks during downturns – when their share prices might reflect a
greater bargain price. Too often, these misplaced buybacks actually
destroy shareholder value.
While investors rightly focus on share buybacks as a potential positive
for equity returns, not all buybacks are the same. Investors must try
to sift through some of the noise that too often surrounds stock
buybacks and be able to separate the wheat from the chaff.
Pacifica
Partners
Capital
Management Inc.
This
report is for information purposes only and is neither a solicitation
for the purchase of securities nor an offer of securities. The
information contained in this report has been compiled from sources we
believe to be reliable, however, we make no guarantee, representation
or warranty, expressed or implied, as to such information’s accuracy or
completeness. All opinions and estimates contained in this report,
whether or not our own, are based on assumptions we believe to be
reasonable as of the date of the report and are subject to change
without notice. Past performance is not indicative of future
performance. Please note that, as at the date of this report, our firm
may hold positions in some of the companies mentioned.
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