Companies should resist buyback temptation

August 24, 2011

By Robert Cole
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

LONDON — Share repurchases are creeping back into fashion, and they are easier to fall for when markets are on their knees. But boards have too often sanctioned stock-buying programmes that have destroyed value. They need to resist the rising temptation.

The number of U.S. companies announcing buybacks is at its highest for nearly three years, according to TrimTabs Investment Research, though the volume of buybacks is shy of what was seen in the past two earnings seasons. Given the recent vulnerability of the market, a wave of buybacks suggests U.S. companies may be doing better than usual at buying low and selling high.

But that hope can also be merely self-fulfilling, at least in the short term. London firm Smithers & Co. reckons that a new spate of buybacks could spur a rally in U.S. equity prices. The firm adds, however, that this effect could be short lived, because it thinks shares remain fundamentally expensive and investors should sell into any buyback-inspired bounce.

And fundamental worries about buybacks persist. True, a board has a duty to run an efficient balance sheet that suits the relevant company’s characteristics. But directors should focus on managing and investing in the business with a view to paying a sustained stream of future dividends. Only hindsight can confirm whether or not a share buyback was a good investment decision — and that’s the main reason a board should undertake one. There’s a suspicion that some managers like engaging in buybacks to beef up their own pay, or at least to massage earnings per share numbers and hence the stock market, and those aren’t valid justifications.

Terry Smith, the veteran London-based analyst and investor, has observed that, since 1972, U.S. dividend-paying stocks have produced annual total returns (meaning appreciation, including any triggered by buybacks, plus dividends) of 8.3 percent a year. Stocks in companies which don’t pay dividends, but may still sometimes undertake buybacks, have returned a paltry 1.4 percent per annum.

That stark difference might narrow if boards could time buybacks more astutely. But that’s a tall order. Regular dividends, meanwhile, put cash in all investors’ pockets, leave market timing to them, require management discipline, and avoid any real or imagined conflicting motivations. If a company can afford to part with cash, investors should prefer dividends to buybacks.

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