Capital allocation is a key driver for management in delivering long-term returns to shareholders, whether through dividends, share buy backs, managing leverage or looking to grow a business through R&D and M&A. Share buy backs have gained in prominence in recent years. Although more likely to be found in the US, increasingly management of UK corporates are utilising this mechanism as part of their capital allocation strategy. The value of UK share buy backs almost tripled between 2021 and 22 to £56.5bn. Globally, the volume of share buy backs has tripled in value since 2012 and now amounts to over 90% of total dividends paid out versus 50% over the prior decade.¹

When companies buy back their own shares, they are in effect reducing the number of shares in circulation, which in turn has three outcomes. Firstly, the earnings per share is improved, a measure that is often used to determine management compensation, and secondly, the price/earnings (PE) ratio, a commonly used valuation metric, is lowered which makes the business more attractive to potential investors. Finally, the dividend per share paid out is lifted with a reduction in the number of outstanding shares, again another potential tailwind for investors. However, the question remains: do investors benefit in the long-term from share buy backs?

The Good

Next, the UK retailer, which can trace its history back to 1864, is a good example of management using discipline when it comes to share buybacks. Under the long serving CEO, Lord Wolfson, the number of shares in issue have fallen from 340mn to 128mn since 2000. Notably, Lord Wolfson uses a measure called “equivalent rate of return” (ERR), which compares the earnings enhancement of buying back shares versus the profits that would have been achieved from investing the cash elsewhere. The CEO who has been in charge since 2001 should be commended for his consistent approach on share buybacks, something that cannot be said of other CEOs in the UK. Long-term shareholders have benefitted, with Next shares returning 2,350% vs the FTSE All Share at 190% since 2000 (14.6% per annum vs 4.6% for the index), on a total return basis (GBP).²

The Bad

The timing of share buy backs remains the key driver in determining which category they fall in and one example that stands out is Apple. The Cupertino headquartered behemoth has bought back nearly $600bn of shares over the past decade, which is greater than the market capitalisation of 493 companies in the S&P 500. This has happened during a period when Apple became the first trillion-dollar company and is now rapidly hurtling towards a $3 trillion market cap. During that period Apple shares have significantly outperformed the NASDAQ – 1,300% vs 300% (USD total return basis). However, the question remains: have management overpaid for their own shares?

The criticism is that management have used shareholder cash to enhance EPS growth, a key metric on which they are both incentivised and compensated. In the case of Apple, which only began paying dividends in 2012, would shareholders have been better off if management had invested the cash in the market, increased the R&D investment, hiked the dividend or undertaken M&A? The stunning performance of Apple shares may have distracted investors from challenging management on the cost benefits of such a sizeable buy-back programme. In addition, the business has taken on debt in recent years to pay dividends at a time when debt was ultra-cheap. That is no longer the case, and it will be interesting to see how management now execute capital allocation at a time of rapid change in monetary policy and an escalation in the cost of debt.

The Oil & Gas sector has delivered a spectacular 2022 for shareholders with companies buying $135bn of shares, a fourfold increase on 2021. In the US, Chevron announced a staggering $75bn share buy back program representing 20% of its market capitalisation.³In the UK, Shell and BP are continuing with large share repurchase programmes, with estimates that the former will buy back the equivalent of nearly 7% of its current market capitalisation annually.⁴Questions are already being asked why this capital is not being allocated to finance transition acquisitions and to de-risk the oil & gas portfolios and how this will detract from funding investment in renewables and wider carbon commitments, which in the case of Shell is to become a net zero emission business by 2050.⁵

The Ugly

International Business Management (IBM) remains the long-term poster child for poor capital allocation by management. The business has spent over $200bn in share buy backs since 1995, during which the NASDAQ has returned 2,100% over that period vs 1,250% from IBM (USD total return basis). The current market cap of IBM is $120bn. Investors should have challenged successive management on the rationale for buying back shares versus investing that cash elsewhere – deleveraging, increasing dividends, M&A or investing in the market. Other notable names in the hall of shame include General Electric and Citibank. Long suffering IBM shareholders can only look on with envy and exasperation at Apple’s near $3 trillion current valuation.

Capital allocation

Capital allocation remains a zero-sum game, with share buy backs coming at the expense of investments (R&D and capex), M&A, dividends or deleveraging. The US continues to dominate the share buy backs landscape, but the UK is showing strong signs of catching up. In the Responsible and Sustainable EdenTree UK Fund, holdings that have bought back shares in the last 12-18 months include Ferguson (£2.5bn), NatWest (£800mn), Smiths Group (£742mn), Sage (£300mn), Spectris (£300mn), Berkeley Group (£117mn), Mears (£20mn), Ashtead (£210mn), Bellway (£100mn), London Stock Exchange (£750mn) and Lloyds (£2bn) – representing a quarter of the total portfolio (end of May 2023). Not all of these capital allocation decisions will yield long-term returns to shareholders and time will show where management have added value or the polar opposite.

So, to answer the question: do investors benefit in the long-term from share buy backs? There remain very few good examples of management executing well on share buy backs, to the benefit of long-term investors. Dividends remain a key driver of long-term performance, with a record year in 2022 in terms of total pay outs and 2023 set to be even better with a forecast of $1.64 trillion, a 5% increase. The sharp increase in interest rates and the cost of debt will lead to a very different capital allocation landscape for management, with more focus on deleveraging and growing dividends in a sustainable manner. In this environment, investors will need to continually scrutinise the rationale of capital allocation by management.

Source

1. https://cdn.janushenderson.com/webdocs/H051739_0523.pdf
2. Bloomberg 21.06.23
3. https://www.reuters.com/business/energy/chevron-raises-annual-buyback-outlook-up-20-bln-2023-02-28/
4. https://www.investorschronicle.co.uk/news/2023/06/05/are-share-buybacks-really-worth-it/
5. https://www.shell.com/media/news-and-media-releases/2023/shell-publishes-reports-on-sustainability-climate-and-energy-transition-lobbying-and-payments-to-governments.html
6. EdenTree Investment Management
7. https://cdn.janushenderson.com/webdocs/H051739_0523.pdf