Do Buybacks Create Shareholder Value?

Foreword from ShareInvestor

This article “Do Buybacks Create Shareholder Value” by Goh Eng Yeow was first published in The Straits Times on 08 Jun 2015 and is reproduced in this blog in its entirety.

Purchases can trigger share price rise but jury still out on merits of exercise

For an excellent example of how a share buyback can create shareholder value for investors, look no further than Pacific Century Regional Developments.

This Singapore-listed company is controlled by Mr Richard Li, the younger son of Hong Kong’s richest man, billionaire Li Ka Shing.

Since the company embarked on an aggressive share buyback exercise last year, its share price has enjoyed a big boost as other investors have jumped into the fray to join the buying spree.

A share buyback is just as its name suggests: when a company embarks on a programme of buying its own shares in large numbers from the market.

The stock has risen 80.7 per cent in price to 47 cents since January – its highest level in 13 years.

The buying interest has been partly spurred by speculation that Pacific Century may be taken private by Mr Li.

This is because the reduction in the free float of shares caused by the buyback has caused Mr Li’s stake in Pacific Century to push close to the 90 per cent delisting threshold.

The company has also continued to forge ahead with further share purchases, seemingly heedless of the fact that its free float is fast approaching the 10 per cent level which may cause it to be delisted.

Still, despite the shining example shown by Pacific Century, some investors in other listed firms remain to be convinced of the merits of share buybacks.

Take Genting Singapore for example. At its recent annual general meeting, one investor wanted to know why it had spent $170 million buying back its own shares last year when it continued to dish out a paltry one cent a share dividend to shareholders. This made the sum spent on the share buyback much bigger than the amount paid out on dividends.

He was questioning the wisdom of Genting adopting such an approach in view of the many examples shown by real estate investment trusts (Reits) and other high dividend-paying stocks whose share prices had been buoyed by their handsome payouts.

In his reply, Genting’s chairman Lim Kok Thay trotted out the usual arguments to support the share buyback strategy.

He said: “A share buyback is used by all major corporates. It sends out a signal that the company and management know best the value of the business. As the number of shares is reduced, it will improve all the ratios which investors consider to be important.”

And challenged by another investor to give reasons why investors should hold on to Genting shares, Mr Lim again brought up the share buyback issue, noting that when the share price peaked at more than $2, the company did not rush into the market to buy back any shares.

His advice was to watch out for any move the company might make if its share price fell. “You can take it from there and make your own decision,” he said.

In the first quarter of this year, Genting spent about $37.3 million buying back its own shares at prices ranging from 91 cents to $1.02.

Last Tuesday, it resumed its share buyback spree, buying 136,000 shares at 90.5 cents apiece, followed by another two million shares at 91 cents each the following day.

But what is interesting about the debate at Genting’s AGM is that it took place against the backdrop of considerable soul-searching among market experts internationally about the merits of share buybacks.

One concern raised, especially in the United States, is that the extremely low interest rate environment has given corporate America more of an incentive to invest in its own shares than in plant and equipment, often by using borrowed money.

Even the Bank for International Settlements (BIS) – the so-called bank for central banks – has weighed in with its own observations on share buybacks, according to the Financial Times.

It noted that the BIS had suggested in a recent study that company executives prefer to indulge in financial engineering, rather than real-world businesses, since their compensation is frequently tied to the performance of their stock.

Some market pundits have even argued that what is keeping the bull market alive on Wall Street has been the big sums spent on share buybacks by companies, even though profit margins have been falling and there is a lack of investment opportunities.

And what about the argument that the share buyback is one of the options a firm may take to spend its cash if it believes its stock is trading below its worth?

Detractors argue that, far from sending a positive signal, such a move may cast a negative pall over a company’s business prospects, since it implies that the company may lack a pipeline of projects that offer a more attractive return on investments and therefore no further reason to drive its share price higher.

However, the bigger worry is that once investors become addicted to the share price gains brought by share buybacks, it behoves companies to continue shrinking their float if they can. Otherwise, they may find punishment awaiting them as vengeful investors find themselves deprived of their share buyback fix.

But then another question arises: Are buybacks still appropriate if a company’s valuation grows too high? A buyback in this case would mean the company’s precious cash is being used to buy something that is overpriced.

Fortunately, corporate Singapore does not have to address this issue yet. So far, most blue-chip firms have used the share buyback scheme sparingly to purchase shares as “treasury stock” to be reissued to management and staff as part of their performance award schemes.

Pacific Century aside, the question is still wide open as to whether share buybacks actually create shareholder value for investors.