Home Money Why are so many companies engaging in share buybacks and what does it mean for the UK market?

Why are so many companies engaging in share buybacks and what does it mean for the UK market?

by Elijah
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Buyback bonanza: Estimates suggest half of UK companies in major markets have bought back their shares

In recent weeks there has been a flurry of large companies announcing share buyback programs.

Just this week, Holiday Inn owner IHG announced a new $800m (£633m) buyback plan. Other well-known names have launched similar programs in recent months.

It’s part of a long-term trend in which companies are eschewing dividends in favor of buybacks to return capital to shareholders. Some estimates suggest that around half of main market companies have bought back shares.

While this might have become a popular option for large companies, it is not as well understood by investors.

We look at why so many people are buying back their shares and what this means for both the UK market and investors.

Buyback bonanza: Estimates suggest half of UK companies in major markets have bought back their shares

Buyback bonanza: Estimates suggest half of UK companies in major markets have bought back their shares

What are share buybacks?

Share buybacks are another way for companies to return excess stock to shareholders by purchasing their own shares, canceling them and ultimately reducing the number of shares outstanding.

One of the main reasons a company buys back shares is because it believes its shares are undervalued. Reducing the number of shares issued can help increase the value of the remaining shares.

In practical terms, companies often prefer buybacks to dividend payments because they are more flexible. Companies can’t really start increasing dividends without being fairly confident that they will be able to continue paying them to shareholders.

Opting for a buyback when there is excess cash means that when tougher times come, they can be stopped and companies are less likely to face criticism than if a dividend is cut.

Buybacks are also often favored because they can be more tax efficient, as capital gains can be taxed at a lower rate than dividend income.

But buybacks also generate a lot of debate. Critics say that if a company’s stock price rises after a buyback announcement, short-term investors can profit.

They also say that reducing the number of shares outstanding will make it easier to earn bonuses tied to earnings per share.

Why are more and more British companies choosing to buy back shares?

Share buybacks have been a major feature of the US market, especially in technology companies, while dividends have been a bigger priority in the UK.

This month Uber announced a $7 billion share buyback after reporting its first operating profit for the full year.

But research shows that, for the second year in a row, large UK companies have almost matched those in the US when it comes to buybacks.

This marks a big difference from previous activity, where US activity has outperformed every other major market.

Last year, the proportion of British companies making major buybacks surpassed that of the United States: 13 percent of British companies bought back at least 5 percent of their shares, compared with 9 percent in the United States.

So why have buybacks become so popular in recent years?

Share buybacks have been a major feature of the US market, with Uber announcing a $7 billion one this month.

Share buybacks have been a major feature of the US market, with Uber announcing a $7 billion one this month.

Share buybacks have been a major feature of the US market, with Uber announcing a $7 billion one this month.

UK companies are trading at a huge discount, around 10.8 times their forecast 2024 earnings, well below the long-term average level of more than 13 times.

Investors neglecting UK stocks means companies are looking for buybacks

Jason Hollands, CEO of Bestinvest, says: “With UK share prices so undervalued, companies that have cash on their balance sheets should use some of this money to buy their own shares and then write them off to reduce the shares by “It’s a pretty compelling form of self-help rather than just waiting and hoping that investors will eventually become interested in the UK again.”

Investor interest in the UK is waning amid economic uncertainty and doing little to change the “unloved and undervalued” moniker the UK has reluctantly adopted.

“If companies do not act to support their share prices, international predators could soon emerge and take a bargain by acquiring UK companies,” Hollands adds.

Ian Lance and Nick Purves of Redwheel, who run the Temple Bar investment fund, have taken this view. They point to Next, which managed to generate a total return of 15.4 percent annually between 2001 and 2021, when sales grew just 4.6 percent annually, largely due to a share buyback program that reduced shares in circulation by 60 percent. .

Late last year, Lance said the buybacks would lift depressed valuations for UK shares.

Others are more cautious about buybacks and prefer to invest excess cash in the company.

Brendan Gulston, co-director of the WS Gresham House UK Multi Cap Fund, says: “This is better aligned with your core skill set rather than determining share-level valuations and optimal times to buy back your own shares.”

What do more buybacks mean for the UK market?

In the short term, increased buybacks will put more cash in shareholders’ pockets and go some way to galvanizing the market again.

Darius McDermott, CEO of FundCalibre, says: ‘In the past, one of the weaknesses of the UK market is that it has overly distributed its cash flows among income-hungry investors.

«One of the consequences of the pandemic is that it has given many companies the possibility of lowering their dividends to a more reasonable level. This has left them with more cash to reinvest, allowing them more flexibility to do things like buy back shares.’

Share buybacks can be an attractive use of capital, especially when valuations reach acute levels of dislocation.

But it is not without problems. Hollands says: ‘While buybacks can definitely help increase returns for shareholders and could simply be the catalyst the UK market needs to reignite investor interest, they are not without criticism.

“When companies themselves become the largest buyers of their own shares, some would say it would be better to return the cash to shareholders in the form of higher dividends, so they can decide where to invest it.”

While there has been criticism that the market is losing from IPOs and more companies delisting, Schroders strategist Harry Goodacre suggests buybacks also remove shares from markets.

An analysis of net buybacks and new entrants/delistings reveals that in the 12 months to December 2023, net equity supply was negative in the US, UK, Japan, France and Germany.

“While much attention has been paid to the decline in the number of publicly traded companies, we must not forget the contribution of share buybacks to the deequitization trend,” says Goodacre.

“For the second year in a row, the use of non-US share buybacks has been much more common than in the past, and that’s despite a higher interest rate environment.”

However, given how undervalued UK shares are, share buybacks might seem like the only option for some companies.

Gulston says: “In certain circumstances, share buybacks can be an attractive use of capital, especially when valuations reach acute levels of fundamental dislocation.”

Hollands adds: “When UK shares are cheap and dividend yields are attractive, I am in favor of companies buying back their shares to increase returns for shareholders.” It could be just what the UK market needs.

What do buybacks mean for investors?

In general, investors tend to like share buybacks because they receive some of the excess cash from the company in which they are shareholders.

Investors tend to assume that the buyback will reduce the number of shares and increase the company’s value per share, but how much does it increase the value in the long term?

“An increase in buybacks may also indicate a lack of profitable investment opportunities for the company in question,” says Goodacre. “Therefore, rather than something positive, investors could interpret it as something negative.”

But McDermott believes some investors misunderstand buybacks and “there is a misperception that somehow (they are) a bad thing because companies should invest instead.” This is totally wrong… share buyback is very simple.’

For investors, they are a more tax-efficient way to receive excess capital because, unlike dividends, they are not taxed or pay a much lower rate.

McDermott says, “That’s why Warren Buffet will carry out Berkshire Hathaway share buybacks if the stock gets too cheap, but it has never paid dividends.” When done right, a buyback can add tremendous value to shareholders.

‘Equally, if a company is in trouble and sees its business collapsing, it is a common mistake for management teams to try to improve sentiment with a share buyback, which can result in throwing good money after bad.

“The bottom line is that it depends on the situation, but buybacks can be very effective and investors should not be irrationally and emotionally against them.”

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