Making sense of how companies return capital
It is at about this time of year when many companies have their annual general meetings, declare their dividends and may announce a share buyback program. Share buybacks are controversial, to the extent that former President Biden introduced a tax on them. In this article we look at the reasons why companies buy back their own shares, and why it can be quite so controversial.
Economically, with caveats we go over below, companies should be indifferent to paying a dividend or buying back stock. In both cases, cash leaves the company and ends up in shareholders’ pockets, either to spend or reinvest. This recycling of capital, taking money out of mature companies with surplus cash and reinvesting in new areas of the economy, is important if we want to create the jobs of the future.
Some CEOs love to build empires using a company’s spare cash. They love to do deals and acquire other companies, many of which do not work out. Other CEOs fixate on expansion and sales growth, regardless of the value it may or may not add to the business. If the CEO knows shareholders expect spare cash to be returned to them, then it creates discipline. A CEO is expected to take risk, but only with the expectation of value-added return. A CEO knows that she is accountable and that she will be out of a job very quickly if she wastes shareholder cash.
Occasionally, a company will return too much cash to its shareholders, leaving itself in a weakened financial position. Thames Water could be an example of a company that paid dividends that were too large. However, provided the cash return does not endanger the company, it is generally thought to be a healthy thing that helps prevent waste.
A company may also find that the best investment they can make is to buy their own stock. Scottish Mortgage in the UK, for example, has set aside £1bn to buy back stock because the directors want to demonstrate their confidence in the company. Often companies with low stock prices will announce buybacks to send this message, and with its shares trading at a discount to Net Asset Value (NAV), Scottish Mortgage is no different:
Source: AMInsights. Scottish Mortgage Investment Trust discount over the last 3 years.
Having said this, buybacks can be slightly more complex than paying a dividend. If a company chooses to buy back stock, it impacts its Earnings Per Share (EPS) calculation. EPS is calculated by taking the net profit after tax for the year and dividing it by the number of shares in issue. If there is a stock buyback then net profit probably remains the same, but the denominator, the number of shares, falls. So, a stock buyback will usually boost EPS.
Critics believe that the boost to EPS is an artificial way to inflate management pay because they believe that EPS is a major element of management compensation. Generally, management compensation is built upon a balanced scorecard which looks at many factors including total shareholder return (which allows for EPS growth).
There is another reason that companies may prefer buybacks to paying a dividend. Buybacks are seen as discretionary and more flexible than dividends. Shareholders like to see a slowly rising regular dividend. If the dividend is cut it tends to mean that the company is in some difficulty, and the share price can fall dramatically. Share buybacks do not have the same problem.
Some shareholders also prefer buybacks over dividends particularly if their investments are subject to tax. In most countries, dividends are taxed more heavily than capital gains, so returning cash by buying back stock is preferred. Some investors may prefer dividends, but it is generally true that it is more tax efficient to buy back stock.
Source: EPFR
Some commentators are critical of dividends and buybacks. They regard them as an admission that the company has limited areas for profitable investment. This criticism is due to unrealistic expectations. The corporate world is a competitive place and all companies, particularly larger ones, find that they have limited opportunities for profitable investment and growth. Returning cash to investors is less of an admission and more of an acknowledgment of reality.
The Groundwork Collaborative, a US think tank, says “instead of contributing to public revenue… or investing in their workers or innovation, corporations diverted billions into stock buybacks and dividends to benefit their executives and shareholders.”
This is illogical nonsense. Any buyback or dividend is paid after the company has paid everything else including all its payroll tax, property tax and corporation tax. It is false to say companies do not contribute to public revenues. All this is clearly set out in any company’s annual report for those who are prepared to look.
Similarly, if companies are to survive in today’s hostile world they must train staff, innovate and continually evolve. These costs are necessary just to stay in business. It is management’s job to balance innovation, staff training, tax and shareholders’ requirement for a return. If they can balance all these requirements successfully then management should be rewarded. Do shareholders benefit? Absolutely, the Groundwork Collaborative are correct. However. if shareholders did not benefit, they would not invest in a company to start with, and then where would the money come from to contribute to public revenues, invest in workers and innovation or donate to think tanks?
At Callanish Capital we are supportive of returning cash to shareholders if it does not endanger the company. We are agnostic as to whether it is returned by dividend or buyback, although some investors have different preferences. When you are told that dividends or buybacks are harmful to shareholders or beneficial to CEOs, as Warren Buffet said in his 2022 shareholder letter “you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
This document contains general information only and does not provide any advice or guidance specific to your personal circumstances.
Callanish Capital is authorised and regulated by the Financial Conduct Authority to manage investments but does not provide Financial Planning or Investment Advice. Please refer any such queries to your Financial Advisor.
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