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.
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.
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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