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Financial Times: Shareholders taking a stand on handouts

By Chris Hughes
Published: May 19 2007 03:00 | Last updated: May 19 2007 03:00

Investors used to be grateful when companies promised to return buckets full of cash. These days they seem to shrug their shoulders at corporate handouts. Many are even rebelling against the most common method of cash-return – the share buy-back.

Last year was a record year for cash returns to investors, with UK companies funnelling £108bn their way, according to Morgan Stanley. That includes £46bn of share buy-backs, up from about £28bn in 2005.

But fashions are changing and share buy-backs by UK companies are expected to be only £23bn this year, although BT this week said it planned to spend £2.5bn repurchasing its own stock.

Buy-backs took off because they were a simple and flexible means of distributing cash generated by rising corporate profitability.

They work like this. A company instructs its broker to purchase its shares in the stock market. These shares are then cancelled, which means the company’s future profits are spread among fewer shares, so each remaining share becomes more valuable.

But buy-backs are not necessarily a good thing. They absorb cash that could be spent on higher annual dividend payments or capital expenditure.

If a company’s stock is overvalued, the company wastes money buying it – just like any other investor. And to the extent that stock repurchases are good for the company’s continuing investors, they are correspondingly bad for those who sell out during the buy-back.

Shares in companies that have been growing dividends have performed better over the past decade than those pursuing buy-backs, according to Morgan Stanley.

Private shareholders have long opposed buy-backs because they think they cannot participate in them. This is a fallacy given that anyone can sell shares in the market during a buy-back and the price at which buy-backs are conducted is regulated.

At Royal Dutch Shell’s annual meeting this week, a disgruntled shareholder drew applause when he thanked the oil company for stopping its share buy-back, citing Morgan Stanley’s research.

“You’ve returned £16.3bn in dividends and buy-backs. Thank you for my dividends, I have banked them,” he said. “Tell me, how do I bank my buy-backs? . . . Where is [the money] exactly?”

There was a similar incident at the Unilever annual meeting the following day.

Institutional investors are also taking a stand. Stuart Fowler, fund manager at Axa Investment Managers, says: “We prefer dividends to buy-backs and we state that very plainly to companies that ask. You would have thought that by now more companies would have spotted what Morgan Stanley has found.”

He says that companies such as BPB, BAA, BOC might still be independent if they had paid higher dividends and therefore commanded higher share prices – a lesson for Rio Tinto, which is currently the subject of takeover speculation.

“Rio is the sort of company where putting the dividend up would help defend its borders,” he says.

Euan Stirling, investment director, UK equities at Standard Life, says: “There can be value creation from buying back cheap shares. But if companies have a permanent increase in their cashflows, dividends are the best way to distribute this to shareholders. There is plenty of scope for UK companies to grow dividends from here.”

Other investors want cash to be spent on capital expenditure instead. Robert Waugh, head of UK equities at Scottish Widows Investment Partnership, says: “Buy-backs can make sense at the right price, but we prefer good management to invest more in the business. At the moment most investment is going on expensive acquisitions.”

Neil Darke, analyst at Collins Stewart, has campaigned against ill-judged share buy-backs, arguing that investment banks advise companies to do buy-backs because their equity desks make easy commission from them. He says other means of capital return – such as special dividends or redeemable “B” shares – are preferable, since they do not differentiate between selling and buying shareholders.

But management at companies that have been buying back shares are quick to dismiss criticism.

Ted Tuppen, chief executive of Enterprise Inns, says investors seem to prefer buy-backs because they do not trigger a taxable event like a dividend.

“When we asked our shareholders, the overwhelming response was that they preferred share buy-backs. But fashions change, and you get to a point when it’s not earnings enhancing.”

Mr Tuppen says companies are not being cajoled into buy-backs by bankers, since it is possible to negotiate very low commission rates with brokers.

Jim Clarke, finance director of JD Wetherspoon, says: “Most of our long-term large shareholders have said they see buy-backs creating more value than putting up dividends.”

He says the company buys its shares when their free cash-flow yield exceeds its cost of borrowing.

Ian Burke, chief executive of Rank, says: “There are a lot of factors that influence the decision about how you return capital. We have used both buy-backs and a special dividend.”

So should companies continue buy-backs? It depends. Collins Stewart research has found that buy-backs trigger share price outperformance when the company also has a low valuation, a reputation for disciplined capital investment and a strong balance sheet. “A buy-back is only a catalyst for correcting undervaluation – it is not a value creator in itself,” says Mr Darke.

Copyright The Financial Times Limited 2007

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