When Share Buybacks Go Bad

Published in Investing on 1 June 2011

Terry Smith argues that most share buybacks destroy value. How does this happen?

In City circles, Terry Smith is known as a straight-talking, no-nonsense critic of dodgy corporate practices.

Lifting the veil

Today, Smith is best known as CEO of broker and FTSE 250 member Tullett Prebon (LSE: TLPR), but his City career stretches back to 1984, when he first started out as a stockbroker.

While head of UK company research at UBS Phillips & Drew, Smith acquired a degree of notoriety for his best-selling book Accounting for Growth. In this exposé, Smith stripped away the camouflage from company accounts, revealing the creative accounting used to flatter company performance.

Following publication of his book, which criticised several of his employer's clients, Smith left UBS Phillips & Drew in 1992 and embarked on the path which ultimately took him to the top of Tullett. In November 2010, Smith launched Fundsmith, a low-cost fund manager.

Cooking the books

As a direct result of Smith's revelations, some Financial Reporting Standards were changed to remove (or reduce the impact of) some of the most flagrant accounting fiddles.

However, almost 20 years after Accounting for Growth was released, companies today still use a number of accounting loopholes in order to manipulate their reported profits and give the impression of growth.

For example, in a recent blog post, Smith puts the boot into share buybacks, which have both friends and foes here at the Motley Fool.

Destroying value

Smith's argument is simple: by and large, most share buybacks destroy value for remaining shareholders. However, while buyback programmes are undertaken with the intention of creating shareholder value, they often have the opposite effect.

How and why does this happen? The simple answer is that companies destroy value because they use shareholders' cash to buy shares trading above their intrinsic value. Alas, this destruction of value is rarely obvious, as both the cash used and the shares purchased 'disappear' from a company's balance sheet after buybacks.

On the other hand, by buying back its equity, a company reduces the number of shares in issue and, therefore, boosts its earnings per share (after buybacks, the same earnings are divided by a smaller share base).

With directors' incentives -- such as share options and long-terms incentive plans --- largely based on raising earnings per share, the motivation to buy back shares becomes compelling.

Thus, blatant self-interest sways boards to vote for ill-thought-out share buybacks, rather than returning spare cash to shareholders in the form of higher dividends, special dividends, or returns of capital.

Bad buybacks

Smith argues that allocating capital is one of 'the most important decisions which management of companies make on behalf of shareholders.' Regrettably, few company directors, investors and analysts understand the true impact of share buybacks.

Of course, buybacks create value only when the shares purchased are trading below intrinsic value. Also, management should not undertake buybacks if, in Smith's words, 'there is no better use for the cash which would generate a higher return.'

In short, buybacks appear to be a lazy, unthinking, highly conflicted way to use shareholders' cash to buy assets of lesser value.

What needs to change?

To correct this destruction of shareholder value, Smith is pressing for the following changes:

1. Management should justify share buybacks by reference to the price paid and the implied return and then compare this with alternative uses for the cash.

2. Investors and commentators should analyse share buybacks on exactly the same basis as they would if the company bought shares in another company.

3. Investors and commentators should use return on equity to analyse the effect of share buybacks, rather than the impact on earnings per share.

4. Share buybacks should be viewed with a high degree of scepticism when done by companies whose directors are incentivised by EPS growth.

5. Accounting for share buybacks should be changed so that the shares remain as part of shareholders' funds and as an equity-accounted asset on the balance sheet in calculating returns.

Taken together, these five steps would kill off 'bogus buybacks' at a stroke. No longer could earnings per share figures be flattered by using the owners' cash to buy back shares above their intrinsic value.

This would force directors to look for better ways to 'splash the cash', perhaps through sensible acquisitions, reinvestment for growth or, even better, higher dividends. After all, no amount of accounting tricks can take away a higher cash sum in investors' pockets.

(To illustrate his arguments, Smith has produced a paper on buybacks, together with PowerPoint slides. You can download a zip file containing both documents here.)

Two Foolish views

I can't speak for all Fools, but I've long been a critic of share buybacks. This is largely because I have seen the value destroyed by large-scale buyback programmes.

For instance, I've owned shares in drug Goliath GlaxoSmithKline (LSE: GSK) since the early Nineties. For the first half of this 20-year period, GSK rarely bought back its rapidly rising shares. Instead, it preferred to undertake large-scale acquisitions, such as Glaxo's purchase of Wellcome in 1995.

However, since the turn of the century, GSK has spent billions of pounds buying back its shares. Alas, over the past decade, GSK's share price has been in steady decline and is down almost a third (30%) since June 2001. What's more, GSK's net debt has increased throughout this period so it is, in one sense, using borrowed money to buy back its own shares.

In other words, GSK's massive buybacks of the past decade have done nothing but use shareholders' cash to buy assets which have declined in value. Frankly, if I'd wanted to own a depreciating asset, I'd have bought a new car.

Lastly, my Foolish friend Stephen Bland (alias PYAD; himself an ex-accountant), is also no fan of share buybacks. For many years, Stephen has argued that buybacks are a bone-headed idea, as 'it is impossible to see the effect of buybacks on the wealth of the investor'.

Also, Stephen argues that most buybacks, by artificially boosting EPS, are about 'enhancing directors' reputations [rather than] enhancing shareholders' wallets'. I'm sure Terry Smith would agree!

More from Cliff D'Arcy:

> Both Cliff and The Motley Fool own shares in GlaxoSmithKline.

 

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

MunroMan 01 Jun 2011 , 1:08pm

Cliff, do you really think an AMC of of 0.9% is low cost these days?

MunroMan 01 Jun 2011 , 1:25pm

For a fund that aspires to a 5% turnover ratio selling one, unspecified, holding out of just 23 seven months after launching doesn't look great.

A lot of what Smith says makes sense, but transparency and doing what he said he would do don't seem to be part of it.

theRealGrinch 01 Jun 2011 , 2:17pm

manipulation of "provisions", "bad debts" and "goodwill" are 3 of the most obvious "fine tunes" underaken. you can raise or lower them one year on another to raise profits and bonuses.

goodlifer 01 Jun 2011 , 5:39pm

Am I just wet behind the ears, or does the way CWC's buying back its shares suggest they've no immediate plans to cut their dividend?

LeeJG 02 Jun 2011 , 1:25pm

IT's these types of practices that keep the money of the general populace well out of shares. It needs not transparency and accountability before it can be a wise investment.

LeeJG 02 Jun 2011 , 1:26pm

It is these types of practices that keep the money of the general populace well out of shares. It needs transparency and accountability before it can be a wise investment.

Understudy23 02 Jun 2011 , 2:33pm

Anyone have a view on Grainger's recently announced buyback and whether it should be taken up?

Offer is: 1 bought back for each 238 held
Buyback price:

Understudy23 02 Jun 2011 , 2:33pm

Anyone have a view on Grainger's recently announced buyback and whether it should be taken up?

Offer is: 1 bought back for each 238 held
Buyback price:

Understudy23 02 Jun 2011 , 2:38pm

Apologies, PC had a spack attack.

Anyone have a view on Grainger's recently announced buyback and whether it should be taken up?

Offer is: 1 bought back for each 238 held
Buyback price: 149p
Current sp: 126.5p

I've tried to sell my entire stake on the offer but doubt I'll get it. This seems to be a no brainer or am I missing something? Payout would happen just after end of June.

Dozey1 02 Jun 2011 , 9:56pm

A very good article. I'm no accountant but it seems to me that shareholders' cash should be returned to them if the company concerned has no idea what to do with it. Glaxo is certainly a good example; Vodafone is another.
Morrisons is the latest to exercise my mind. A very good and progressive outfit with plenty to do in the fields of web presence, home delivery and convenience stores. Also cash rich and hoiking the dividend. Why on earth should they wish to buy their own shares at the highest they've been for years? Doesn't stack up IMHO.

MikeGG1 03 Jun 2011 , 8:13pm

There are 2 types of buy-back. The Grainger idea is a means of returning cash to shareholders when it isn't needed for growth.

The other type is the buying of the shares on the market which I think is the type that the article was about. There the shares are overpriced and the premium paid is wasted.

Mike

Karellan 19 Jun 2011 , 7:03am

With thinly traded shares like VCTs its probably the only way that the shareholders can realise their investment.

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