A fear of being taken over by private equity groups could be behind the surge in share buybacks in the UK, according to Nick Shenton, manager of the Artemis Income fund.
FTSE 100 companies have announced close to £33bn worth of share buybacks so far in 2022. Even though it is only April, this is already the third-highest figure in any year since 2000, behind only 2006 (£33.6bn) and the £34.9bn record set in 2018.
While buybacks push up share prices, it is not all good news for investors. Russ Mould, investment director at AJ Bell, pointed out the best time to buy back shares was when prices were low and represented the best value for money – but activity tended to peak under the opposite scenario.
“Buyback activity reached its high in 2006 to 2007, as animal spirits were running most strongly just before the financial crisis swept the world,” he said.
“More than £60bn in buybacks across those two years did nothing to support share prices in 2007 to 2009. Buybacks slowed to just £3bn in 2009 by the time the crisis was passing and equity markets had collapsed and thus became much cheaper.”
Shenton went even further, saying the spike in buybacks was being driven by management teams who are desperate to keep their jobs, and hope that pushing up share prices would save them from private equity buyouts – which were also surging.
Data from KPMG showed mid-market private equity investment in the UK in 2021 soared to the highest level ever recorded. Both volumes and values saw a boost, as a total of 803 deals – worth £46.8bn – were completed in 2021. This represented an increase of 40% and 36% respectively on the previous year.
“We’ve got good valuations [in the UK], which is attractive,” said Shenton. “An interesting thing that we’ve never seen before is we’ve got close to 50% of the portfolio by capital buying back stock as well.
“After they've invested in the business and they've paid dividends, there's surplus capital, and if they don't buy back shares, they're not rewarded by passives – passives like share buybacks and dividends.”
He added: “Also, private equity can use these companies’ balance sheets to buy them. And our guess would be that in boardrooms in the UK in the past year or so, they have looked at the amount of incoming deals from private equity and thought, ‘our share price is leaving us vulnerable’.”
On the plus side, Shenton said it was not as if these companies were taking on debt to buy back shares; nor did the trend mirror the “scam in the US”, where often buybacks only cancel out the issuance of share options, and companies were valued on adjusted earnings per share [EPS] which excludes the diluted effect of share issuance.
“That’s a cost to the business: if the number of shares is going up each year, your share of the business is going down, but it seems somehow to be excluded from analysis,” he said. To account for this practice, he and co-managers Adrian Frost and Andy Marsh analyse free cashflows after share buybacks.
Artemis Income has made 127.4% over the past decade, compared with gains of 104.9% from the IA UK Equity Income sector and 102.1% from the FTSE All Share. The £4.8bn fund has ongoing charges of 0.8% and is yielding 3.6%.
Performance of fund vs sector and index over 10yrs
Source: FE Analytics
Mould said he has no idea whether buybacks were being used to put companies out of the reaches of private equity bidders, but warned it would be a sign of poor management if it were true, pointing out that “draining cash would make it harder to survive the next downturn or defend the business’s competitive position”.
He added that there were two questions to consider when a company buys back stock: first, would this money be better spent investing in the business?
“Ultimately, the investor is taking a stake in the firm’s ability to provide goods or a service better, or cheaper, or more effectively than its rivals (or possibly all three),” he explained.
“Without satisfied customers, there will be no business at all, so the would-be investor must ensure that the firm is spending enough on research, product development, capital investment and marketing before it gives away any cash.”
Second, were company executives buying stock with their own cash as well as the company’s? Mould pointed out that this would be a more reliable indicator they felt there was value in the company.
However, he accepted that when buybacks were carried out in a disciplined manner, it could create shareholder value, pointing to Next as a rare example of a company that does this efficiently.
“It does not buy back stock willy-nilly at any price, like so many of its FTSE 100 peers,” Mould continued.
“It buys back stock when the purchase brings it an equivalent rate of return (ERR) of 8%. It calculates ERR by dividing pre-tax profit by the market cap.
“At the time of writing, [chief executive officer] Lord Wolfson’s guidance for the year to January 2023 of pre-tax profit of £860m compares with a market capitalisation of £7.8bn. That implies a buyback would bring an ERR of 11%, so the firm may look to supplement its regular dividends with a stock repurchase programme.
“Next paid out £2.3bn in dividends and £1.9bn in buybacks over the past decade. Those buybacks have taken the share count down from 181 million to around 127 million, increasing the stake of anyone who chose not to sell by almost a third.”
Performance of stock vs index over 10yrs
Source: FE Analytics
Data from FE Analytics shows Next has made 178.9% over the past decade, compared with gains of 102.1% from the FTSE All Share.