Share buybacks – good or bad?

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Mitchell Fraser-Jones 21 July 2015 Est. reading: 3 min read

By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders.”
Warren E. Buffett, Letter to Berkshire Hathaway shareholders, 1984

Share buybacks are controversial and for good reason. As the chart below demonstrates, some companies, in the US at least, have form in buying back shares at the wrong time and at the wrong price.

Chart showing the percentage of US S&P 500 companies buying back shares alongside the S&P 500 index

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.

Chart showing the share price of Next over time, along with the remaining shares in issue.

What are the risks?

  • The value of the fund and any income from it may go down as well as up, so you may get back less than you invested
  • Past performance cannot be relied upon as a guide to future performance
  • The ongoing charges figure is charged to capital, so the income of the fund may be higher but capital growth may be restricted or capital may be eroded
  • The fund may invest in other transferable securities, money market instruments, warrants, collective investment schemes and deposits – some of these security types could increase the fund′s volatility and increase the level of indirect charges to which the fund is exposed
  • The fund may invest in overseas securities and be exposed to currencies other than pound sterling – as a result, exchange rate movements may cause the sterling value of investments to decrease or increase
  • The fund may invest in unquoted securities, which may be less liquid and more difficult to value, because they are generally not publicly traded – the lack of an open market may also make it more difficult to establish fair value

Important information

Before investing, you should read the Key Investor Information Document (KIID) for the fund, and the Prospectus which, along with our terms and conditions, can be obtained from the downloads page or from our registered office. If you have a financial adviser, you should seek their advice before investing. Woodford Investment Management Ltd is not authorised to provide investment advice.

The Woodford Funds (Ireland) ICAV (the “Fund”) has appointed as Swiss Representative Oligo Swiss Fund Services SA, Av. Villamont 17, 1005 Lausanne, Switzerland. The Fund′s Swiss paying agent is Neue Helvetische Bank AG. All fund documentation including, Prospectus, Key Investor Information Documents, Instrument of Incorporation and financial reports may be obtained free of charge from the Swiss Representative in Lausanne. The place of performance and jurisdiction for all shares distributed in or from Switzerland is at the registered office of the Swiss Representative. Fund prices can be found at www.fundinfo.com.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address 9400 Garsington Road, Oxford OX4 2HN.

Woodford Patient Capital Trust plc is incorporated in England and Wales, company number 09405653. Registered as an investment company under section 833 of the Companies Act 2006. Registered address Beaufort House, 51 New North Road, Exeter, EX4 4EP.

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