Share buybacks: the pros and cons
The following is an excerpt from The First Bermuda Investment Primer, segment two of the Bermuda Pondstraddler Fundamental Financial Planning Primer Series.
When Warren Buffett, the highly respected, legendary investment manager mentions corporate share buybacks, global capital markets take notice. They should, for in 2018 alone, Berkshire Hathaway repurchased $418 million of its shares. Mr Buffett, earlier this year mentioned a further possible buyback of $100 billion, an enormous sum by any measure.
His company, Berkshire Hathaway is the fifth largest company in the S&P 500 Index by market capitalisation; also, having the most expensive share price in history. The Class A shares were priced at more than $307,000 each on the stock market yesterday.
In 2018, US companies’ share buybacks totalled more than $1.1 trillion — much of this activity attributable to the US Tax Cuts and Jobs Act provisions’ special low-cost tax incentives for repatriation of US multinational corporations’ foreign earnings.
Corporate share buybacks, sometimes called share repurchases by publicly traded companies, have figured in local investing, too: with Bermuda Stock Exchange-listed companies Ascendant Group Ltd, One Communications Ltd, BF&M Ltd, Argus Group Holdings Ltd and LOM Financial Ltd among those active.
What is a share buyback programme?
Why would companies take this action?
What does it mean for consumers?
Do share buyback programmes increase the overall value of a corporation share value?
Who benefits from the buyback?
First, let’s revisit a broad overview of a stock’s, or share’s beginning.
Shares of publicly traded companies, generally, get their start in a brief, general series of illustrative steps.
• Example: a tiny unstructured business, maybe a partnership, or just an informal group of two friends decide to protect their individual monetary and intellectual contributions made to their business.
• They legally incorporate the promising new business as a private company. Shares are not allowed to be sold to anyone outside the initial two people that incorporated the company. Each individual shareholder owns equal shares of 50 per cent (5,000 at $1 per share) of the company. Readers, this is not far-fetched. Apple started in Steve Jobs’s family’s garage.
• The company grows exponentially; additional capital is badly needed. Investors, venture capitalists, banks and others express financial equity interest.
• An initial public offering to the general public of one million new shares is proposed. The Group2, their new name and as primary shareholders, will retain a total of 52 per cent interest, 26 per cent each, with 48 per cent for sale to the general public whereby no one individual or company can own more than 5 per cent of the shares.
• Investment bankers, securities lawyers, accountants, valuation analysts, brokers descend like bees to honey, valuing the shares for the opening launch.
• The IPO is positively oversubscribed — more buyers than the total of shares offered. The company Group2 is cash flush. There are now thousands of new shareholders owning a piece of the company. Dividends may be paid in the future — depending upon profitability and board of director approval.
Group2 now has publicly traded shares that exist within the secondary market security trading platforms, can be bought, sold, and bought again — their market valuation constantly subject to actual corporate financial data, global market stressors, economic signals, interest rates, consumer discretion, and many more investment indicators.
The recognised share market value of a company is used extensively by loan institutions, insurance companies, investment margin accounts, etc as collateral and backing in their contracts.
A share buyback, also known as a share repurchase, occurs when a publicly traded company buys back a significant number of its own outstanding shares in these markets.
Corporate share buybacks are initiated for various reasons with advocates and detractors of these initiatives.
In the 1980s, the US Securities and Exchange Commission changed its stance with rule 10b-18, corporate share buybacks. Prior to the Act, CSBs were illegal due to perceived biased market manipulation — as buybacks drove up the market sales price.
Reasons provided for the change in US securities law that a company could buyback their shares included:
• An alternative method to reward shareholders, rather than dividends;
• Increase share value by reducing supply in open markets;
• Satisfy the financial expectations of future share holders by using idle cash more productively;
• Keep values stabilised for loan collateral purposes;
• Enable shareholders, including corporate insiders, to capture the appreciation in value at a different tax threshold than dividends;
• Reducing cashflow allocated to dividends;
• Utilise excess cash that is not easily deployed elsewhere to repurchase undervalued stock, then when markets correct, reissue said shares at a profit;
• Implementing anti-takeover target strategies where repurchases utilise accumulated cash to increase ownership control and reduce takeover incentives. Reason — excess cash on a takeover company’s balance sheet can be used to pay down debt incurred in a hostile acquisition.
Detractors take contrary positions relative to the share buyback strategy:
• CSBs boost prices in the short run, but boosting value long-term should be focused on future investment;
• Companies with significant debt should focus on debt reduction rather than share buybacks;
• Companies borrowing to finance buybacks may face tighter cash and credit controls in an economic slowdown;
• CSBs benefit executive management when their compensation is tied to share growth valuation and other benchmarks;
• CSBs should be bought when undervalued, not overvalued;
• CSBs increase earnings per share, but may not concomitantly increase fundamental value.
Next week, more investment discussions and facts.
US Securities and Exchange Commission: 1. Section 240.10b-18 provides an issuer (and its affiliated purchasers) with a “safe harbour” from liability for manipulation under sections 9(a)(2) of the Act and § 240.10b-5 under the Act solely by reason of the manner, timing, price, and volume of their repurchases when they repurchase the issuer’s common stock in the market in accordance with the section’s manner, timing, price, and volume conditions. Wikipedia. Share Repurchase.
AAII Journal, March 2015: “Stock Buybacks: Misunderstood, Misanalysed and Misdiagnosed”. by Aswath Damodaran.
“A beginner’s guide to stock buybacks (and why they’re not all bad)”, by Robert Samuelson, The Washington Post, https://tinyurl.com/y3qhwtux
• Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Dual citizen: Bermudian/US. Pondstraddler Life, financial perspectives for Bermuda islanders and their globally mobile connections on the Great Atlantic Pond. Finance columnist to The Royal Gazette, Bermuda. All proceeds earned from this column go to The Reading Clinic. Contact: email@example.com