Categories
Current International

The case against share buy-back schemes

Shareholders invest their savings in companies to gain some return on their investment. The norm used to be in the form of dividends, but over time companies have rather been buying back their own shares and assumed that this would increase the value of each share. They reasoned that it is Tax efficiency. It should be discouraged.

One of the great characteristics of a free and vibrant capitalistic economy is that there are many companies who are listed on the various stock exchanges and anybody has the ability to purchase shares in those companies and thereby get their share of the fortunes generated by the companies they invested in. This is non-discriminate allows anybody, no matter what their background is, to participate in corporations’ fortunes by investing in them. Everyone can be part owners without the need of actually establishing a business oneself, something that is much more difficult, stressful and often disappointing than it seems in theory. As a return the companies us the profits twofold. They use part of the profit to invest in future projects that should enhance the future of the company. The rest of the profit is returned to their shareholders in the form of dividends. That has changed over time, and recently many companies preferred to return most of the money due to shareholders by buying back the companies own shares. The reasoning given is that it is a more Tax efficient way of returning money to shareholders, because it would not attract withholding tax but only the much lower capital gains tax, if any at all. There are three reasons why this should be illegal.

Firstly, it muddles the true performance of the company. Management use the capital, that could have been returned to shareholders in form of dividends to pay for shares, and thereby increase the earnings per share (EPS), without increasing the revenue line at all. It suits them, as most of their performance is measured by the EPS, but it shifts more risk onto the shareholder because they now need to time the sale of their shares to realise their value of the apparent increased profitability. But, as it is obvious in the current Covid19 crises, even shares with increased EPS fall in a crash. But is also makes the live of an investment analyst much harder. The timing and the pricing of the bought back shares plays a crucial part of the valuation and the determination of the return on shareholders capital.

Secondly, managers of companies have a very poor record of determining what a fair value is. Anglo American bought billions of their own shares back at the hight of the 2008 commodity bubble. Back then, the share price was approaching R550, which was never to be seen again. The most laymen equity Investor could not have done a worse job themselves. Managers often struggle to unlock value by buying companies, just think of the massive write downs at Woolworths after their disastrous decision to spend half their market capitalisation on a department store in Australia, while there is a worldwide trend away from department stores. Or look at EOH, where the previous management had a never-ending appetite for acquisitions. That worked well when the share price raced to R150, but now at R3.40 their market capitalisation is much smaller than many of their acquisitions. If they have such trouble allocating capital efficiently in their own field of expertise, how would you expect them to judge their own share price realistically and unbiased?

The third reason is the most important though. If the companies always pay out a share of the profits in the form of dividends, it gives the investor the ability to decide themselves what to do with the cash inflow. If they feel that the company is undervalued, they might just buy more shares themselves. But they also can spend the income on anything else they might desire, not necessarily in the investment world. They might use the money to pay towards their next car or might use it pay for their next holiday. Clearly this has got a much wider and a more positive impact on the economy.

In a world where we are once again talking about Taxpayers bailing out big companies, it is important to understand that should the companies just resort to buying back their own shares when they return to profitability, thanks to Taxpayers money, the wider economic impact will be very limited. The main beneficiaries are the managers, followed by the shareholders. The wider society, who are the sole reason for their survival will have limited benefits. Paying out dividends in cash will broaden the impact substantially.