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The Times: Share buybacks are in vogue, but keep an eye on the dividend

EXTRACT: It must be noted that 90 per cent of British share buybacks by value have been carried out by just 20 companies, led by Vodafone, BP and Shell, which between them spent £21 billion last year alone.


May 19, 2007
Nick Hasell: Tempus

Last year may have set a record for share buybacks, but on the evidence of the past week British companies have lost none of their appetite for repurchasing their own stock.

Over the past five days alone, four FTSE 100 stalwarts, BT Group, Compass Group, Enterprise Inns and National Grid, have announced plans to mop up an additional £5.4 billion worth of their own shares. Given that corporate Britain is estimated to have spent £46 billion on buybacks in 2006, a heady 64 per cent increase on the previous year, declarations of intent to acquire a sum of more than one tenth that tally in a single week indicates that 2007 should be another banner year. Nor is this purely a domestic phenomenon. On Wall Street, the likes of ExxonMobil, GE, Goldman Sachs and Microsoft are mopping up their own shares with brio. S&P 500 companies are estimated to have bought back $110 billion (£55.6 billion) of stock in the first quarter of this year, on top of the $800 billion they have spent in the previous two years.

However, a study by Morgan Stanley is likely to give finance directors on both sides of the Atlantic pause for thought. The US investment bank concludes that if the purpose of a buyback is to boost a company’s share price, returning cash to shareholders through raising the dividend is a far more effective method.

It found that, since 1997, the average share price rise of companies that have been consistently increasing their payout has been 12.7 per cent a year, outstripping the 10.3 per cent gain achieved by the wider market. However, the average performance of companies that have pursued share buybacks was only 8.2 per cent. In fact, the only years in which buybacks helped share prices to outperform were 1997, 2001 and 2002, when fierce bear markets were running.

Even better, shares in companies with top-quartile dividend growth rose by 20 per cent a year, while those with top-quartile buyback programmes – companies that bought back the most shares relative to their stock market value – could manage only a 12 per cent advance.

In short, stock markets reward companies that grow their dividends strongly, while, other than in falling markets, they appear on average to penalise those that conduct buybacks.

Of course there is no strict reason why buybacks should boost share prices. In theory, a company purchasing its own stock reduces the number of shares in issue without affecting its stated earnings, therefore enhancing its earnings per share and by extension, its share price. But that is akin to sleight of hand. Given that the company has spent cash to purchase the shares, the stock market should take into account the reduction in both shares and cash, such that one cancels out the other.

So why have buybacks become so popular? It was not so long ago that a company buying back its own shares was seen as tantamount to an admission that it had run out of ideas on how to expand. Surely stock markets allocate capital to companies for them to create wealth with it, and not so that they should meekly hand it back again?

That rationale has seen what were previously viewed as growth companies punished for returning cash in the past. Most famously, shares in Merck fell 15 per cent in 2000 after it opted to spend $10 billion on its own shares rather than on developing its R&D pipeline. Similarly, the $27 billion buyback conducted by IBM in the late 1990s was widely taken as a sign of corporate malaise.

Last year, 58 per cent of British companies conducted buybacks, against just 14 per cent in 1997, according to Morgan Stanley. One explanation for the shift is that companies, having been precluded from engaging in M&A by their weak share prices, emerged from the postmillennial bear market with significantly strengthened balance sheets.

Here, share buybacks serve three important functions. First, as a display of confidence. They allow a company’s management to signal to the stock market a belief that its shares are undervalued. Indeed, academic research has shown that the best-performing share buybacks have been those in which the company’s executives are not among the selling shareholders. Secondly, they are able usefully to rebalance a company’s capital structure by retiring expensive equity in favour of cheaper debt financing. And thirdly, they provide enviable flexibility: the stock market would take a cut to a share buyback programme in its stride in a way it would not take a cut in a dividend. But if buybacks have not worked as they should, that does not invalidate the theory. It must be noted that 90 per cent of British share buybacks by value have been carried out by just 20 companies, led by Vodafone, BP and Shell, which between them spent £21 billion last year alone. With so-called “mega caps” being among the worst stock market performers of recent years, partly because they are too big to be bid targets, their preference for buybacks is surely not the whole problem.

So if strong dividend growth is the path to outperformance, where should investors put their money? Look for a low net debt to equity ratio and high surplus cash yield, says Morgan Stanley. That means Dana Petroleum, BG Group, Inchcape, Burberry and Michael Page International, among others and its sister websites,,,,, and are all owned by John Donovan. There is also a Wikipedia article.

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