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BOUQUETS FOR SHARE BUYBACKS ...

1 April 2000

Leithner & Co. seeks to invest in excellent companies. A defining feature of such companies is that they allocate capital rationally; accordingly, under certain conditions they use excess capital to repurchase their own shares. Several of the companies in our portfolio are either currently undertaking or have in the past several months undertaken share buybacks. This circular describes share buybacks, distinguishes “good” from “bad” buybacks and justifies my predilection for good buybacks.

Background

To own a company’s shares is to own a pro rata claim to its earnings. A company which earns profits (or possesses capital which is surplus to requirements) must by logical necessity adopt one or some combination of three possible capital management policies. First, it can retain these funds within the company in order to expand operations, buy other businesses, buy corporate jets, etc.; second, it can return them to shareholders on a proportional basis in the form of dividends; and finally, by buying its own shares the company can return capital to those owners who prefer to exchange their shares for cash.

Changes in the Corporations Law enacted in 1989 and 1995 have made it much easier for Australian companies to repurchase their own shares. As a result of these changes, in the past several years both the numbers and dollar amounts of repurchases have increased considerably. According to figures compiled by Dr Jason Mitchell of the University of Western Australia, in the 1994-95 financial year there occurred 11 buybacks totalling $0.7b. In 1995-1996 there were 27 buybacks worth almost $2.0b and in 1996-1997 there were 47 buybacks worth $3.4b. A study of ASX figures conducted by The Australian Financial Review for the 1998-1999 financial year uncovered 71 repurchases with a total value of $8.8b (which includes BHP Co. Ltd’s $4.2b unwinding of its internal Beswick structure). In calendar 1999 there were 87 buybacks worth $11.9b, and so far this year major companies such as Foster’s Brewing Ltd, North Ltd and Woolworths Ltd have announced buybacks.

According to many commentators, the Commonwealth Government’s expected acceptance of proposals set out in the Ralph Report, which recommend that the rate of income tax paid by companies and capital gains tax paid by individuals be reduced, will (other things equal) increase the attractiveness of buybacks relative to dividends. If the proposals are fully implemented, then individuals at the top marginal rate would pay tax on unfranked dividends at a rate of nearly 50%, but would pay capital gains on shares sold through a buyback at a rate of only 25%. As we shall see, however, the government’s implied encouragement of buybacks – like all interventions which favour one and discourage another course of action – is a decidedly mixed blessing.

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Why a Buyback? Why Not a Dividend?

Some investors take the view that a Board which undertakes a share buyback and thereby shrinks the company’s capital base in effect abdicates its responsibility to increase the business’s size and profits. It seems to me, however, that Directors’ duty is not to increase a company’s profits but rather to maximise its profitability. Directors, in other words, are bound not to enlarge the resources at their disposal but to put those resources to the most efficient and effective possible use. Hence when earnings cannot be retained to good effect within a company – and particularly when its shareholders can achieve better returns by re-investing these earnings elsewhere – a conscientious Board will return capital to shareholders. And as the experiences of BHP, Burns Philp, GIO Australia and others remind us, at all times it is far better for companies to return capital than to squander it in ill-conceived expansions.

This principle describes the conditions under which a return of capital is preferable to the retention of earnings. But what kind of return of capital – dividend or repurchase of shares? To answer this question, consider as an example a company whose capital structure consists in 1000 shares and $1000 of shareholders’ equity (that is to say, the company’s assets exceed its liabilities by $1000) which includes profits of $100 earned during the year. Assume that it has $100 of capital which is surplus to requirements, cannot be put it to good use within the company and will therefore be returned to shareholders. The company’s book value is therefore $1000/1000 shares or $1 per share, earnings per share (E.P.S.) are $0.10 and return on shareholders’ equity (ROE) is $100/$1000 or 10%. Finally, assume that the market price of the company’s shares is $1 (i.e., ten times earnings per share) and that all shareholders have purchased their shares at this price.

If the company distributes its excess capital in the form of a dividend, then the dividend is $0.10 per share and all shareholders earn 10% ($0.10/$1.00) on their investment. If in the following year it again earns $10, then E.P.S., ROE and book value remain exactly as described above.

If, however, the company uses the $100 of excess capital to repurchase 100 of its own shares at the prevailing market price, then those who sell into the buyback receive $1 per share. The company then cancels the repurchased shares and its capital structure shrinks to 900 shares and $900 of shareholders’ equity. Book value remains $900/900 shares or $1 per share. If in the following year the company again earns $100, then E.P.S. and ROE increase, respectively, to $0.111 and 11.1%; and if the price-earnings ratio remains at 10, then the price of each share will increase to $1.11. The share buyback has thus increased the efficiency with which the company uses its capital. In do doing – and even though its profits have not increased i> – the resultant increase in price returns 11% ((1.11-1)/1) to the remaining shareholders. Over time, then, and given “other things equal” assumptions, a given amount of capital returned via a buyback can be worth more to the remaining (long-term) shareholders than the same amount returned via a dividend. As well as providing a direct return to remaining shareholders, a buyback can also signal Directors’ determination to allocate the company’s capital more effectively.

Implicit in this example is the critical importance of the price at which the company repurchases its shares. Results of three scenarios (i.e., buybacks at $0.80, $1.00 and $1.25) are set out in the table below. It shows that the repurchase price does not affect the extent of the company’s more efficient use of capital: regardless of repurchase price, ROE increases from 10% to 11.1%. The repurchase price does, however, influence the shares’ book value. It also influences returns to sellers and remaining shareholders: the higher the repurchase price, the higher the return for the minority who sell and the lower the return for the majority who hold their shares. Indeed, if shares are repurchased at $1.25, then the return to remaining shareholders (9%) is less than the return which would have accrued from a dividend (10%). Conversely, the lower the price at which the company conducts the buyback, the lower the return for the minority who sell and the higher the return for the majority who retain their holdings.

Repurchase @ $0.80 Repurchase @ $1.00 Repurchase @ $1.25
Book Value $1.029 $1.00 $0.978
E.P.S.

$0.114

$0.111

$0.109

ROE 11.1% 11.1% 11.1%
Return (Holders) 14% 11% 9%
Return (Sellers) -20% 0% 25%

This simple example thus clarifies the grounds for undertaking a share buyback in addition to – or rather than – a dividend. Given earnings which are surplus to requirements, and given the likelihood that earnings will continue at a similar or higher level, the greater (less) the extent to which the price of a company’s shares is undervalued, the more a buyback (dividend) will be advantageous to the majority of shareholders. And unlike the dividend, the buyback also provides Boards with a means of exercising “lazy” balance sheets. It enables the company’s earnings to be spread over a smaller capital base, thereby increasing earnings per share. Assuming that other factors such as the price-earnings ratio remaining equal, it thereby encourages an increase over time in the price of the remaining shares.

A final point emerges from this example: there is no necessary reason to believe (as some studies of buybacks seem to believe) that the effect of a buyback will be immediate. Although short-term speculators may well bid up the price of the shares, the key benefit is to long-term investors and will manifest itself over time. Further, note that this benefit pre-supposes the existence of real rather than accounting profits, and its purpose is to use shareholders’ funds more effectively – not to maintain or increase the share price.

These points place into context the results of a study, published in Barron’s Online on 14 February 2000, of buybacks undertaken in the U.S. during 1999. It listed the 50 companies in the Standard & Poor’s 500 which repurchased the biggest percentage of their shares. The market price increases of only 8 of the 50 exceeded that of the S&P. Indeed, the prices of 33 of the 50 decreased and their weak results have continued into 2000. Christine Callies of CS First Boston, who compiled the data, offers an explanation: “with many companies last year, big buybacks were more a reaction to some sort of distress than any portent of success.” Indeed, one of the trends these days is for some companies to announce weak results and, in order to distract attention from those results, trumpet a big buyback in the hope that the repurchase of shares will alleviate the pressure upon their price.

An anonymous value-oriented portfolio manager quoted in the Barron’s article also noted that the poor performance of the heavy repurchasers is not surprising: unlike high-multiple companies such as Microsoft, Cisco Systems, Walmart and GE, which had small buybacks relative to their enormous market capitalisations, many of the companies undertaking large buybacks in 1999 sold at low multiples to their earnings. Low-P/E stocks, however, were distinctly out of favour last year.

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Characteristics of a “Good” Buyback

Our simple example places in sharper relief the characteristics of “good” and “bad” buybacks.

Shares Are Bought at a Low Price

A good buyback does not attempt to place a floor under the prices of shares. Quite the contrary: we have seen that in order to maximise returns to remaining shareholders, Directors’ objective should be to repurchase shares at the lowest possible price.

An example from 1998 illustrates this point. As recounted by Mathew Carr in The Australian Financial Review, John Gowing, Managing Director of Gowing Brothers, the men’s clothing retailer based in Sydney, does not like to miss a bargain. So when (for reasons he believed to be unrelated to the operations of the business) the price of his company’s shares began to decrease, he promptly announced a share buyback. The company stated that it would repurchase to 1m of the 47.6m shares on issue; and by August 1998 had bought approximately 0.5m shares at an average price of $2.14 per share. The company paid up to $2.30 per share; and when the price decreased to $2.05, buyback activity accelerated. Asked if he was disappointed because the buyback had not given the company’s share price a short-term fillip, Mr Gowing said: “we were not trying to do that. I’m actually trying to buy them as cheap as possible.”

Indeed, and in the words of Timothy Vick, author of the excellent book Wall Street on Sale, “few things should irk an investor more than managers who blow shareholders’ cash by repurchasing stock at inflated prices. This problem reached epidemic proportions [in the U.S.] in 1997 and 1998.” Normally, high and rising share prices give Boards an incentive to issue equity (in effect, selling an asset worth, say, $1.00 for $1.50) and to use the cash raised thereby to retire debt. Instead, growing numbers of companies are doing exactly the opposite, i.e., going into debt in order to spend $1.50 for an asset which is worth $1.

Cash Rather Than Debt Is Used to Finance the Repurchase

A share buyback entails the transfer of excess capital from a company to some of its shareholders, the cancellation of scrip and therefore a reduction in the absolute amount of shareholders’ equity. If the company’s capital structure contains some percentage of debt, then the buyback will by definition increase that percentage; and if new debt is used to repurchase the shares, then the relative importance of debt in the company’s capital mix will rise further still. The adoption by some Australian companies of their American counterparts’ habit of using debt rather than cash to repurchase their shares is therefore, in my view, a worrying development.

If one accepts that a company with a low level of debt which returns (say) 15% on shareholders’ equity is preferable to a company with a higher level of debt also returning 15% on equity, then it follows that, other things equal – and as in our example – cash rather than debt should be used to repurchase shares. In this respect U.S. President George Washington’s admonition is a good one: “no practice is more dangerous than that of borrowing money.”

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Characteristics of a “Bad” Buyback

Clearly, then, not all buybacks are created equal. Indeed, under certain conditions some may be bad for shareholders.

Smoke But No Fire

If a company announces its intention to buy its own shares under specified conditions, and if those conditions materialise, then the company should buy the shares. (If it does not, then the company’s motives may be open to question: perhaps it is attempting artificially to maintain or increase the price of its shares). According to at least one study, some companies which announce buybacks have little or no intention of actually repurchasing stock: they use the announcement as a means to give the price of their shares a short-term lift. A study of 409 of America’s largest companies which announced buybacks found that nearly 40% failed to repurchase shares in the five-year period following the announcement. Its author, Professor James Westphal of the University of Texas, stated: “in announcing buyback plans, increasing the stock price may be their first objective and, once met, implementation may become less critical.”

Churning Australian Style

The mere announcement that a company will undertake a share buyback may send speculators into a flurry of reaction. But it provides no guarantee that the company will actually shed excess capital. And if a buyback is financed in part or in whole by a Dividend Re-investment Program (DRIP), then the impact of the buyback will be reduced and perhaps eliminated. Under these conditions shares are “churned” – the DRIP issues them and the buyback withdraws them. In the 1997-1998 financial year, one of Australia’s major banks announced that it would repurchase up to 15% of its shares. But it actually repurchased relatively few shares, and its DRIP and buyback largely offset one another. As a result its share capital was not reduced by the trumpeted 15% but only by a mere 1%.

Churning American Style

The headlines are impressive. General Electric broke new ground in 1989 when it announced a $US10b share buyback whose objective was to improve GE’s return on equity. Since then hundreds of American corporations have followed suit. And by 1997 American companies returned to their shareholders $US181b via share buybacks and $US251b via dividends. Looking below the headlines, however, a different picture emerges: the average large American corporation is a net issuer of shares. Indeed, the firms which comprise the Standard & Poor’s 500 have been net issuers in nine of the past ten years. How to reconcile these seemingly-contradictory numbers? More generally, how do we explain the growing and disturbing tendency of companies to incur debt in order to repurchase their shares at inflated prices? By recognising that corporations do indeed buy large numbers of their own shares – but then re-issue them in order to finance acquisitions and remunerate their executives.

As shown in my circular dated 15 April 2000, more and more companies are issuing more and more options over their shares because (they allege) these devices are means par excellence to induce more and more of their employees to become more and more excellent. Besides, their competitors are becoming ever more generous with options; and to retain their world-beating executives, remuneration gurus advise that companies must keep up with the Jones.’ In order to avoid the dilution of E.P.S. and book value which would occur if new shares were issued, these companies buy large quantities of their existing shares to meet the liabilities which their option schemes have incurred. These repurchased shares are then re-issued to employees, thereby diluting the impact of the buyback – and not infrequently leaving the number of outstanding shares virtually unchanged. And because options over their shares are continually vesting, these firms must repurchase their shares regardless of price. In 1997 and 1999 senior Microsoft executives stated that the company’s shares were excessively valued. Microsoft nonetheless repurchased and continues to repurchase large numbers of its shares: in the first quarter of 1997, for example, it spent no less than $US2b – nearly twice its net profit – on its own shares.

The increasing share of stock options in executives’ pay, remuneration consultants allege, is designed better to align executives’ and shareholders’ interests. It seems to me, however, that they may have unintended, disturbing and directly opposite consequences. These consequences, not incidentally, explain the ubiquity of buybacks in America and their growing popularity in Australia. If the announcement of a buyback causes speculators to bid up the price of a company’s shares – and therefore the price of options over those shares – then a CEO who has been granted a large number of options has a strong incentive to recommend that his Board approve a buyback. According to Christine Jolls of Harvard Business School, firms that reward their executives heavily with options are much more likely to repurchase their shares than firms which use options sparingly or not at all. Under these conditions, buybacks enrich executives at remaining shareholders’ expense. In Sanford C. Bernstein’s words, this type of repurchase “largely represent[s] a direct transfer of wealth from shareholders to employees.”

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Leithner & Co. Policy

This circular demonstrates that, if undertaken for sensible reasons and managed competently, share buybacks improve companies’ use of capital and increase their earnings per share; in turn and over time, these benefits tend to bid up the price of their shares and thereby improve returns to the owners of those shares. “Good” buybacks, as I have defined them, thus tend to be undertaken by precisely those companies which attract Graham-and-Buffett style value investors. Decades before they became fashionable on Wall Street, Warren Buffett spoke approvingly of “good” buybacks. And Buffett’s practice of such buybacks through the various Boards on which he served, such as The Washington Post Co., have underscored their worth to investors. (It is worth noting that because Mr Buffett and his Vice-Chairman, Charles Munger, are able to put its earnings to such outstanding use, Berkshire Hathaway has never repurchased its shares. Nor has it paid a dividend since 1967).

From this conclusion follows Leithner & Co.’s stance with respect to companies’ repurchase of their own shares:

  • the existence of a “good” buyback (or a track record of undertaking “good” buybacks) is, other things equal, an indicator that the shares of the company which undertakes it may be worth buying and holding;when an excellent company whose shares we own undertakes a “good” buyback, we will as a rule retain our stake – i.e., not sell them into the buyback – and thereby reap the long-term benefits which derive from owning a proportionately-larger stake of the enterprise;
  • conversely, the existence of a “bad” buyback (or a track record of undertaking “bad” buybacks or not returning excess capital to shareholders in an appropriate manner) is, other things equal, an indicator that the shares of the company which undertakes it are not worthy of purchase or retention.
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