THE TIMES (UK): PERSONAL INVESTOR: Share buybacks create an illusion of gain: “Royal Dutch Shell is mounting a £5 billion buyback by way of apology for management lapses. Something must be thrown to the vultures; shareholder’s money is an obvious choice.”: Saturday 20 August 2005

By Graham Searjeant

COUNTRYWIDE, the estate agency chain, achieved a notable stock market triumph when it reported its first-half results. Income was down a fifth and pre-tax profit collapsed from £30.7 million to £3.5 million. The interim dividend was carved from 4.5p to 1p. Yet Countrywide shares stayed firm above 300p, a level implying a complete recovery in the housing market.

The only potentially positive surprise was that Countrywide promised to spend cash saved on the dividend to buy shares back from institutional investors. The board explained that the shares are now owned mostly by Americans, who prefer buybacks to dividends, which suffer withholding tax. UK fund managers, who have notoriously little grasp of risk, did not care either way. So the change was made.

Buybacks invariably discriminate against private investors, who are not wanted. For fund managers, Countrywide pressed just the right public relations button. It has almost become a tradition. If a company has become unpopular with fund managers, either for mistakes, poor management or being in the wrong market at the wrong time, it mounts a share buyback by way of apology and self-flagellation.

One positive message is that the company can afford to reduce its share issue, so will not get into trouble or need more capital. Against the £6.3 million offered by Countrywide, for instance, Royal Dutch Shell is mounting a £5 billion buyback by way of apology for management lapses. Something must be thrown to the vultures; shareholder’s money is an obvious choice.

A study by McKinsey’s Richard Dobbs and Werner Rehm estimates that US companies announced £130 billion of buybacks last year and a further £30 billion in the first quarter of this year. Reuters lists 17 leading UK companies that have announced or undertaken buybacks this year, including 11 in the FTSE 100.

Investment banks correctly point to situations where a share buyback, or preferably a special dividend, makes good investment sense. The case for returning capital to investors is most straightforward when a group sells a division for cash. When a company with a high share rating repays capital, by contrast, it implies that investment opportunities are better elsewhere, so its own growth rating is unjustified.

Such rational arguments can, however, generally be ignored. Buybacks are offered because they suit the interests of various professionals, not the companies or their underlying investors. For instance, the investment banks, which control many of the leading fund managers, earn fees and commissions from buybacks but nothing from dividends.

By shrinking share capital, buybacks should also boost earnings per share, provided that the company is earning more than the costs of capital. This reassures lazy fund managers and helps executive directors to gain earnings-linked bonuses regardless of trade.

The relative value of dividends to UK funds was cut by Gordon Brown’s pensions tax, but fund managers should not be attracted to buybacks simply because they are tax- efficient for Americans. They can, however, play a crucial role for index-tracking funds. Tracker managers cannot sell shares just because they do not like them and often try to justify their fees by being active in governance. Only by bullying an underperforming company to buy back a significant proportion of its shares can trackers cut their stakes.

Dividends and capital spending suffer to provide investment banks with more fees, to ensure that directors earn bonuses and to help tracker managers to overcome the limitations of their chosen form.

McKinsey’s study, which is generally favourable to buybacks, also points to the illusions induced by the nominal boost to earnings. In normal circumstances, buybacks add nothing to total value. The value of the enterprise is reduced by the value of the buyback. If earnings appear to rise, they should be rated proportionately lower because risk has increased. To pretend otherwise is a confidence trick. 

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