All-time high - JSE MAGAZINE

All-time high

Share buyback activity in the US has reached unprecedented levels. What can local investors learn from this?

All-time high

Last year US companies bought back $1 trillion worth of their own stock, smashing the previous record of $589 billion, which was set right before the financial crash in 2007.

This is a big number. It’s just less than half the market cap of the Bombay Stock Exchange or the Deutsche Börse and equivalent to a tenth of the Nasdaq. And though buybacks slowed recently, they’re expected to continue in 2019. According to JP Morgan, companies could buy back another $800 billion of their own shares this year, spurred by higher profits and further cash repatriation inspired by changes to the tax law (which lowered the corporate tax rate to 21% from 35%, and provided a permanent break on overseas profits).

Under the right conditions this is good for shareholders because buybacks take shares out of the market, reduce the share count and thus inflate earnings per share. In the US, as in SA, buybacks are attractive because they provide investors with a modest tax advantage – the alternative, a special dividend, attracts tax. Critics of buybacks argue that the money could be used more effectively – by investing in research and development, acquisitions and business development, or better wages for staff.

However, Warren Buffett – billionaire investor, and chairman and CEO of Berkshire Hathaway – has long argued that stock buybacks are a good use of corporate capital. At the 2004 Berkshire Hathaway annual meeting, well before the company outlined its first official buyback policy in 2011, he noted that ‘when stock can be bought below a business’ value it is probably the best use of cash’. The critical term here is ‘below a business’ value’. In a 2015 interview with CNBC, Buffett noted that ‘many management [teams] are just deciding they’re gonna buy X billions [in stock] over X months. That’s no way to buy things. You buy [things] when [they’re] selling for less than they are worth. It’s not a complicated equation to figure out whether it is beneficial or not to repurchase shares’.

In July 2018, with a cash pile of more than $100 billion and no major acquisition on the horizon, Berkshire announced that it was doing away with the policy of buying back shares only when the stock was trading below 1.2 times book value and, instead, would buy back shares when they thought the company was trading below ‘intrinsic value’.

Locally, companies such as MMI, Glencore, Datatec and South32 have embarked on buyback programmes that appear to be in shareholders’ best interests. Last year AVI announced a special dividend of R2.50 per share, in effect saying that the share price was too expensive to justify a buyback. Bowler Metcalf has done the same, but the motivation is different – the Bowler share is tightly held and trading is highly illiquid, making share buybacks impractical. Yet investors need to keep a wary eye on buybacks. Management teams have a worrying history of buying back shares when prices are highest and (or) when their motive for doing so is not necessarily in ordinary shareholders’ best interests. In 2017 Steinhoff spent about R5 billion repurchasing 78.4 million of its shares. The share was trading at R61 per share, above the firm’s net asset value of R51.12 at the time. With the benefit of hindsight, is it too much of a stretch to wonder whether Steinhoff executives may have allegedly started the buybacks in an attempt to drive up the price?

Under former CEO Jeff Immelt, General Electric (GE) forked out $24 billion in share repurchases in 2016 and 2017, a period in which the share declined from about $30 to $7.15. Now GE is grappling with a cash crunch and has slashed its dividends. While direct comparisons between the US markets and the JSE are not appropriate, there are parallels – and there is no doubt that 2019 is going to be an interesting year. At the extreme end of the share buyback story are complete take-outs. By the end of 2018 Verimark, Howden, Torre Industries, Interwaste, Clover and Cargo had all announced plans for either the majority shareholder or a third party to acquire 100% of the shares and delist the firm.

Many listed companies have seen their share prices fall to below or near intrinsic value and in particular many small- and medium-cap stocks are showing good value. It is certain there will be much more corporate buyback activity this year. Local investors would be wise to keep an eye on the practice.

By Sasha Planting
Image: Haleema Rawoot