Keep An Eye Out for Companies Conducting Share Buybacks

Dear Reader,

Although the new year has barely begun, a flood of half-year results will soon be upon us. The reporting season gets under way in a little over two weeks.

The biggest hitter of all, Commonwealth Bank Ltd [ASX:CBA], is scheduled to release its results on 7 February.

As the ASX’s biggest stock, and barometer of both the banking sector and broader economy, CBA’s result will likely set the narrative for the remainder of the stocks that follow.

The interest margin it makes on its lending, whether loans are growing or contracting. The amount of loans in default or arrears — analysts will pour over the numbers to gauge how the wider economy is travelling.

And for income investors, the most important number of all: the size of the dividend about to head their way.

For those feeling the pinch, it’s a long six weeks as they wait for that dividend to land in their account.

Of all the announcements that come with the results — the headline profit, EBIT, earnings per share, dividend, franking details and others — there is one that some investors loathe. That is, the dreaded share buyback.

What’s the point of using all that surplus cash to buy shares in yourself? Why can’t the company just send extra cash the shareholders’ way?

To them, a share buyback is a bit like — well, maybe a lot like — getting some soap, a pair of socks or box of handkerchiefs for Christmas. You know that they are in some way useful, it’s just that you hoped for something a bit more.

As the name implies, a share buyback is where a company uses excess cash to buy back its own shares. Once it buys the shares, the shares are then cancelled, thereby reducing the total number of shares.

Typically, companies will conduct a buyback in either of two ways.

The first, off-market, is where the company sends each shareholder paperwork/email outlining the details of the offer. The shareholder can nominate the number of shares they’re willing to sell, and the price they’re prepared to accept (usually set as price range by the company).

The other way is for the company to buy the shares on-market, the same way any other investor would buy shares. In doing so, the company will usually lodge a report each day with the ASX, highlighting how many shares they have bought.

Why do companies buy back their own shares?

From the company’s viewpoint, they believe doing so is the best way to use available funds. While a special dividend on top of a regular dividend is a nice boon to the shareholder, it is usually a one-off bonus. A bit of a sugar hit.

However, once the extra cash is gone from the company, the company is less valuable than it was before. The same way a stock normally drops after it goes ex-dividend from its regular dividend.

By doing a buyback, a company’s management are aiming to do something they believe will add value to its shares over the longer term. And, how the market views them.

Reducing the number of shares changes the way investors might value a company.

One popular valuation metric is Earnings Per Share (EPS). After a share buyback, because there are less outstanding shares, EPS will increase even if total earnings remain the same. A potential investor might buy in based on only viewing the improved EPS number.

EPS flows into another popular valuation tool — the Price-to-Earnings ratio (P/E). Investors often see a low P/E as an indication that a stock might be undervalued.

Again, if earnings are flat — yet EPS increases off the back of the share buyback — the company may look cheaper than it really is.

A buyback also helps improve a company’s Return on Equity (RoE) — another key number watched by the market.

Of course, the megafund managers know how to value a business, no matter how many shares it has on offer. One of the reasons they may be sceptical about a share buyback is its timing.

Companies looking to undertake share buybacks face the same issues as everyone else in the market. They could end up buying at the top of the market, thereby burning a hole in their cash pile.

This is especially so in a runaway bull market. Everything else might be too expensive to buy, so the company buys shares in itself instead.

It’s not such a big problem if the market continues heading higher. However, it becomes a much bigger issue if the market rolls over and tanks.

It was this exact scenario that caused so much grief for another ASX giant, BHP Group Ltd [ASX:BHP].

In 2011, BHP spent a whopping $6 billion on a share buyback, at an average of $40.85. By the time the buyback had finished, BHP share were touching $47.

Within a year, however, BHP was trading around $31 as the heat of the commodity boom started to ease. Go forward another few years, and BHP was trading barely above $14.

In this buyback, BHP unwittingly destroyed billions of shareholder funds.

Of course, it’s only with hindsight that you know if a buyback has worked. I’m sure at the time, BHP had the best information available to them.

Getting the funding mix right between how much to keep to reinvest in the business, and how much to pay out to shareholders, is always a tough decision for a company’s management.

Come this reporting season, keep an eye out for companies conducting share buybacks. Ask yourself if you were a new investor, would you be buying around these price levels.

If the market plateaus or falls from here, they too will have bought their own shares at the top of the market. In doing so, burning up a chunk of shareholders’ cash, which could exacerbate any potential share price falls.

All the best,

Matt Hibbard,
Editor, The Rum Rebellion


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