Share buybacks over dividends grow globally

Are there hidden aspects of share buybacks that may put shareholders in a disadvantaged position, asks Hamed Behairy. He concludes that the answer may be yes. “The world’s second largest platinum producer, Implats, suspended its share buyback programme. Cash preservation is the company’s main focus.” –
SENS announcement, 20 November 2008

Share buyback announcements are generally received favourably by market participants because of their anti-dilution merits.

Share buybacks compete with dividends as the source of distributing excess cash to shareholders. There has been a global trend towards more share buybacks than dividends.

According to a recent study by Professor Roni Michaely at Cornell University on companies in the S&P500, company expenditures on stock buyback plans as a percentage of total earnings rose at an average annual rate of 26% over the last 20 years, while dividends went up an annualised 6.8%.

South Africa is no exception. Share buybacks, particularly over the past two years, have increased dramatically in value compared to dividends. From a stratified sample of 45 companies listed on the JSE, that are followed by Cadiz Securities’ corporate governance team, 25 were found to be engaged in share buybacks as well as dividends over the past seven years.

Admittedly, there are a number of advantages for share repurchases over dividends such as flexibility, favourable tax treatment and sending confidence-boosting signals.

However, we ask the question: are there hidden aspects of share buybacks that may put shareholders in a disadvantaged position?

The answer may be yes.

There are three points that need to be addressed:

Firstly, empirical research conducted recently in the United States by MG Holdings Corporate Advisors raises questions about the motivation behind the rapid increase in share buybacks as opposed to dividends. Option holders – managers and other key employees – may be disadvantaged by normal dividend payments as it results in a drop in share price equal to the amount of dividends per share, other things being equal.

However, shareholders participate fully in dividends. To spare option holders the negative impact of a dividend, boards increasingly favour share repurchases in lieu of dividends.

The problem is intensified if boards are not independent. Effectively, shareholder funds are used to increase the value of potentially dilutory securities held by the option holders.

The research shows examples of companies engaged in significant buyback programmes that resulted in a positive outcome for option holders compared to a final negative effect on shareholders, despite the anti-dilution.

There is a possibility of having a number of these cases at home. It may be more than a possibility, because of the high concentration rate of share options in South Africa. On average, 33% of share options in our sample are owned by the top four executives compared to the maximum of 15% according to international best practice.

Secondly, as the data indicates, there has been a huge increase in share repurchases over the past two years compared to dividends. This period was characterised by escalating asset prices in comparison with historical levels.

We seriously question the rationale of some companies in halting their share repurchase programmes because of current economic conditions, now that share prices have declined considerably. We think this clue points to a rationale for buybacks that may not always be as favourable to shareholder as they are made out to be.

Over the past couple of years, it was rare to find value with a sufficient margin of safety in many companies. This has changed and value has started to emerge.

There are a number of cases that show the divergence between the value and share repurchase cycles. For example, Anglo American was active in buying back shares on high multiples from October 2007 until April 2008 after its $4-billion share buyback programme was announced in August 2007.

The company recently denied a report by the Dow Jones that it has suspended its share buyback. A company spokesperson said: “We have not shelved or suspended it. We just have not bought back shares in a while”.

The cash conservation excuse is used repeatedly by executives to justify halting buyback programmes. We don’t disagree on the importance of cash conservation.

However, we are of the opinion that this same point should be raised by shareholders questioning management rationale of spending valuable cash resources in buying back possibly overvalued shares over the past two years.

Is buying back shares at top-of-the-cycle levels the correct way to conserve the shareholders’ cash? Obviously this question is raised with hindsight; however, the valuation levels were compellingly high enough, at least for us, to publicly state that they would provide poor prospective returns.

At Regarding Capital Management (RE·CM), one of the most critical factors in evaluating management is the rationality of the capital allocation decisions over time. We question whether these decisions have been taken in the best interest of shareholders.

In our opinion, buying back shares at 3.3 standard deviations above the long-term average price to book multiple cannot be described as indicating a good capital allocation decision.

As a matter of fact, to preserve the shareholders’ cash, we expect companies to issue shares at these levels of high valuations and buyback when they are depressed – not the other way around!

Thirdly, share repurchases are often among companies’ biggest capital expenditure items.

If a company would like to acquire another company, we are sent circulars explaining the rationale of the transaction along with detailed financial information to help us make an informed decision.

However, all that we get in a share buyback programme is a proxy vote resolution at the back of the annual report and probably one comment from the chief executive officer.

This one line can mean $10bn in capital expenditure, as was the case for BHP Billiton’s recent buyback programme.

The disproportionate treatment of share buybacks compared to other capital expenditure decisions like acquisitions is not justifiable and we think it is reasonable to provide more detail to help shareholders make an informed decision. We encourage shareholders to stop voting for share repurchases blindly.

Shareholder activism is rich in positive externalities. If one or more active shareholders interfere and ask for more information, the rest will also benefit.

At RE·CM, we engage with your investee companies on these issues, in particular: for the reasons cited previously, we don’t consider board members receiving share options as part of their remuneration as independent.

There is a personal gain for these directors who receive options in having share repurchases and not dividends. Thus, their independence becomes questionable. This point has been neglected by the King Report in its two phases. Apparently, this will be reconsidered in the third phase. .

We generally vote against share repurchases in cases where there is a large percentage of options outstanding, again due to the potential conflict of interest. We wrote about this issue in the January 2008 RE·VIEW (see “Share repurchases – what do they mean?” on page 28).

We vote against share buybacks when the directors have been active in selling their own shares. The same entity (management) is making buying and selling decisions on the same security, which could clearly lead to conflicts of interest.

Of course, management invariably claims it is only selling for ‘portfolio planning’ purposes.

Surely management should apply the same ‘portfolio planning’ principles to the capital structures of the firms being managed?

Now that the ebullient market of 2007/08 is out of the window, capital allocation decisions can be appreciated better. We think that, apart from corporate governance issues, shareholders should spend more time thinking about the pros and cons of share buybacks, and not just indiscriminately welcoming them as indicators of value.

Hamed Behary is a corporate governance specialist with RE·CM