Repurchasing stock may not always be the best way to use capital
The past few weeks have seen widespread announcements of share buy-backs, as companies, often with net cash balances, take advantage of a depressed market to pick up cheap stock.
Vale and Kazakhmys, both recently listed in Hong Kong although thinly traded here, have announced buy-backs of US$3 billion and US$250 million, respectively.
While the market often rewards these schemes with a short-lived cheer, many are conducted for the wrong reasons, particularly to prop up share prices. In some cases, they can even leave a business cash-starved and unable to fund its operating activities down the line.
Share buy-backs are carried out for a number of motives, ranging from acting as a substitute for dividends or as a defence against takeovers, to acquiring assets or providing support for employee share schemes.
Their main advantage is to increase earnings per share (EPS), as the EPS is calculated against a smaller base of outstanding shares.
Management teams encourage the practice, as their compensation is often linked to a defined EPS, or to a target price/earnings ratio (PER) - both ratios are boosted by buy-backs. They are a neat way to use excess cash, which can penalise companies valued on the basis of an ebitda multiple, as cash is deducted from the enterprise value numerator.
But more often than not, a share buy-back will be done to support the share price. Share buy-backs are common in times of financial crisis. They are often encouraged by regulators to stabilise markets. In 2008, the US, Japan, India and Indonesia eased buy-back rules.
Even in Hong Kong, where individual buy-backs are often smaller in size and usually more opportunistic, these jumped from only US$334 million in the first seven months of 2007 - just prior to the outbreak of the sub-prime credit crisis - to a combined US$2.6 billion during the worst of that crisis, from August 2008 to February 2009, according to a study by the Hong Kong stock exchange.
In most markets, including in Hong Kong, repurchases can be conducted on- or off-market, pursuant to a general mandate from shareholders, often with restrictions. These include how much stock can be bought on any trading day as a proportion of the average share volume, and within a defined period (usually up to a year or 18 months) and as a percentage of outstanding share capital (generally 10 per cent).
There are also rules on the price at which shares can be repurchased in relation to recent trading levels. Details of, and reasons for, share buy-backs must also be disclosed, and such shares cannot be used to vote in general meetings. These shares are generally cancelled.
Cash available for repurchases is obviously plentiful during bull markets - when company valuations are also higher. Many businesses also raise capital (for example, in the form of bonds convertible into equity at a premium) to do a share repurchase.
Conversely, many companies, including a number of financial institutions with sizeable buy-back programmes but ultimately facing an unforeseen liquidity crunch, have ended up having to issue shares at a price lower than that at which they had previously repurchased stock - effectively destroying capital in the process. It will happen again.
So buy-backs in many cases do not represent the best use of capital for shareholders. Paying and declaring a special dividend, say with an option to reinvest in the company's stock, can sometimes constitute a better option.
Warren Buffett said as far back as 1999 that share repurchases are 'all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price' and that 'buying dollar bills for US$1.10 is not good business for those who stick around'. Indeed.
Philippe Espinasse worked as an investment banker in the US, Europe and Asia for more than 19 years and writes and works as an independent consultant in Hong Kong. He is the author of IPO: A Global Guide, published by HKU Press
