Share buybacks: do investors really benefit?

On April 20, David Einhorn, founder of hedge fund Greenlight Capital sent out his first quarter letter to investors. One of his few moves during the period was "to take another drive in General Motors" in part because GM "acknowledged it might not need quite so much cash lying around earning zero interest and it will begin to buy back shares shortly".

In the first, fairly lacklustre quarter, Mr Einhorn reduced his net exposure by adding to his bearish, short positions, since "valuations are on the high side and earnings are in a precarious spot. There is a good chance earnings will actually shrink this year. We think the market is too high if earnings have in fact peaked," he added.

This year, buybacks and dividends are widely expected to amount to some $1tn for the first time ever, with well over half of that coming just from share buybacks. Quantitative easing has given corporate America more of an incentive to invest in its own shares than in plant and equipment, often by using borrowed money.

In a recent study, even the Bank for International Settlements suggests that cheap finance does not necessarily lead to greater investment. Today executives often prefer to engage in financial engineering rather than in their real world businesses since their compensation is frequently tied to the performance of their stock.

In the first quarter, share buybacks slightly outperformed the broader market, though for the past six months, the share buyback group underperformed, according to Dan Suzuki, an equity strategist with Bank of America Merrill Lynch. But there have been few studies on whether the activity is as beneficial for investors as it is for the executives of companies buying back shares over any significant length of time. Most analysts tend to be cheerleaders, rather than naysayers.

"For four of the last five years, the market has been cheap, meaning it has been a good time to buy back shares," says Mr Suzuki. "But performance peaked in 2013 (while profits peaked in June, 2014) and it has been choppy ever since. There has been this pervasive notion that the way to create alpha [outperformance] is through share buybacks but it has been more mixed than that." Mr Suzuki warns investors they need to be far more discerning from here. Crucially, the more the stock market rises, the greater the downside.

Merrill Lynch, for example, has compiled a list of companies that have underperformed in spite of their share buyback programmes. These cover sectors from chemicals to telecoms, equipment makers to energy companies, and include Hess, Juniper Networks, Deere and LyondellBasell. Of course, it is possible to make the case that without buybacks, the performance would have been even worse but that is hardly encouraging for potential investors.

In addition, investors would do well to remember that share buybacks often involve a sort of negative signalling about business prospects. The implicit message is that companies lack a pipeline of projects that offer interesting returns on investment and, therefore, there are no fundamental factors that might drive earnings higher.

Meanwhile, some companies, particularly in the technology realm, have got into the unhealthy habit of granting stock options to staff and then buying back shares to offset that issuance.

All this comes against a backdrop of a tug of war between the negatives of disappointing data on GDP, retail sales, and inventories, and significant macro headwinds on the corporate earnings front, (in part due to the oil price fall and the strong dollar), and the opposing, positive force of continued liquidity.

Merrill is predicting the first year of negative earnings growth since 2009 and points out there are twice as many downward revisions on earnings as upwards, and downward revisions exceed upside revisions across the board. Meanwhile, liquidity provides a certain floor under shares but at the same time, each bout of stimulus has produced diminishing returns.

History is not always a guide but the last cycle does reinforce the lesson that the more valuations rise, the more perilous such share buybacks can be. In 2007, many companies were buying back shares at what turned out to be peak prices. But after the global financial crisis, when their prices plunged they could not afford to take advantage of the fall.

In other words, in spite of the rhetoric, executives and investors are not always equal beneficiaries of share buybacks.

[email protected]

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation