Questor: simplifying can pay off – but what about spending cash on your own shares?

Comment: Share buybacks

With nearly £33bn of share buybacks already announced by 29 of its members, the FTSE 100 is comfortably on track to surpass 2018’s record of £34.9bn in buybacks. The programmes already announced equate to 1.6pc of the index’s market value and supplement the consensus forecast dividend yield for this year of 3.9pc. The two sums combined do not quite match inflation, but they certainly beat cash and government bonds hands down.

There are four arguments in favour of share buybacks.

First: if a company is generating surplus cash, it can return it to shareholders and let them decide what to do with it, rather than risk it on an unnecessary acquisition or earn nothing on it thanks to low interest rates.

Second: buybacks can work for individuals depending on their tax situation and whether they prefer to be taxed on a capital gain (buyback) or dividend (income).

Third: anyone who elects to retain their shares when a company buys back stock will have an enhanced stake in the business and thus be entitled to a bigger share of future dividends (assuming there are any).

Fourth: they can also suggest that a management team feels a company’s shares are undervalued, so they can be seen as a vote of confidence in its trading prospects.

Equally, there are four reasons to treat share buybacks with some degree of caution.

First: private investors tend to be ignored in buyback programmes.

Second: history shows that companies have a habit of buying stock back during bull markets (when their shares tend to be more expensive) and not doing so during bear ones (when their shares are generally much cheaper).

Third: a buyback could be used to massage earnings per share figures by reducing the share count at limited cost. This could be used to trigger management bonuses or stock options.

Fourth: companies can burn cash or rack up debt when they buy back stock, potentially weakening their balance sheets and competitive position in the long term (although the same danger lurks with dividends).

In this context it is interesting to see Howard Schultz instantly cancel the large buyback programme planned by coffee chain Starbucks when he returned to the company. Schultz is redirecting the cash toward investment in the underlying business, which he clearly feels is being undernourished and therefore weakened in the face of what remains a very competitive market.

Before they take on trust that a buyback is a good thing, shareholders should therefore ask themselves two questions when they consider the merits or otherwise of such financial largesse.

First: to what degree is this financial engineering at the expense of product engineering or investment in the service proposition and competitive position of the company? Ultimately, the investor is taking a stake in the company’s ability to provide goods or a service better, cheaper or more effectively than its rivals (or possibly all three).

Without satisfied customers, there will be no business at all, so the would-be investor must ensure that the company is spending enough on research, product development, capital investment and marketing before it gives away any cash (or worse, borrows money to fund a buyback).

Second: are company executives buying stock with their own cash rather than just the company’s funds? Surely using their own money, rather than that of shareholders, would be a much more powerful signal?

Russ Mould is investment director at AJ Bell, the stockbroker

Read the latest Questor column on every Sunday, Tuesday, Wednesday, Thursday and Friday from 5am.

Read Questor’s rules of investment before you follow our tips.

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