Somewhat worryingly, in recent years, some companies have also potentially been buying back shares in the wrong way! The disconnect between bond yields and equity yields has encouraged many companies to borrow in order to retire equity. This may seem sensible when bond yields are so low but it can add financial risk to an investment case. Thankfully, this behaviour has been more evident in the US than in the UK but it has further tainted the reputation of the share buyback.
Nevertheless, we remain fans of the share buyback in certain circumstances. We believe share buybacks are very sensible as long as:
- The shares to be bought back are purchased at a price below their intrinsic value
- They are typically financed through surplus cash flow
- They do not lead to increased balance sheet risk
- They take place alongside a progressive dividend policy
- They are deployed with flexibility and pragmatism – i.e. they can be turned on and off as appropriate
There are couple of things to watch out for too:
- Share buybacks should not become a mechanism for delivering management incentive plans
- Management shouldn’t starve the business of an appropriate level of investment to make room for a share buyback
Given our active, unconstrained and valuation-oriented investment approach, it can be taken as read that we believe everything we have invested in is undervalued to some extent, often profoundly so. Consequently, we are keen for companies to consider buybacks if they have the spare cash flow and scope on the balance sheet to do so. Where this is the case, a share buyback is a very effective, value-creating way of augmenting shareholder returns and can be the ideal accompaniment to a progressive dividend.
The key here is capital discipline. The share buyback should be the option against which all other capital allocation or investment decisions are based. The board and executive management team of a company should be aware of the return that it would expect to make in buying back its own shares – if other alternatives (investing in its own business via capex or investing in other businesses by acquisition) do not yield a better return, those investment plans simply should not be pursued!
Next is a great example of a business that demonstrates this capital discipline in abundance. As a well-managed, cash generative business, Next often has surplus cash to return to its shareholders. It has been a regular repurchaser of its own shares for years, reducing the number of shares outstanding by almost 60% over the last two decades. In tandem, the company has also raised its ordinary dividend payment by an average 16.8% per annum 1.
But, importantly, it doesn’t do buy back shares at any price – if management views the company’s shares as materially undervalued, it buys them back. If not, it returns excess cash via a special dividend. Either way, the shareholder is rewarded and, in being transparent about price and valuation, Next sends a very powerful message to the market about its capital discipline and the difference between its inherent long-term value and its short-term share price.
Like Warren Buffett, therefore, we are fans of the share buyback in the right circumstances. The chart below demonstrates how Next’s capital discipline has rewarded shareholders in the past. We do not claim to be experts on the quality of this season’s apparel but this discipline should ensure that Next is a share that does not go out of fashion.