In a global equity shareholder yield strategy, there are only five possible uses of corporate cash: reinvestment, acquisitions, dividends, share repurchases and debt pay downs. Reinvestments and acquisitions should be pursued if the firm expects a return higher than its cost of capital.

Otherwise, the best use of cash is to provide shareholder yield. All three forms of shareholder yield — dividends, share buybacks and debt repayments — are effective forms of returning wealth to shareholders. Each adds more or less value at different points in an economic cycle.

According to the Financial Times (12 April 2015), US companies are on course to return US$1 trillion to shareholders in 2015. That’s nearly as large as Australia’s superannuation pool! The article states that more than US$903 billion was returned to investors in 2014 – US$350 billion in dividends and US$553 billion in share buybacks.

The focus of part 2 of this article series is on share buybacks. It seems all the big corporates are doing it, and not just in the United States.

Apple. In its fourth quarter 2014, Apple spent US$17 billion buying back its stock, taking its total spend on share buybacks for 2014 to US$45 billion. This comes on top of more than US$30billion buyback program in 2013.

Nestle. In August 2014, Nestle SA, the world’s largest food company, announced that it planned to spend 8 billion Swiss francs (US$8.8 billion) in its first share buyback in three years after reporting revenue growth that exceeded analysts’ estimates.

Rio Tinto. On 7 April 2015, Rio Tinto announced the successful completion of its off-market buyback program, which was increased to A$560 million from the original A$500 million announced, due to strong demand.

Is it all good news?

Share buybacks have been receiving a lot of attention and press, much of it critical. We read that:

1. Even though corporate profits are high, companies are not investing, but are buying back their common stock instead,
2. Companies are issuing debt to fund share buybacks,
3. Managements are using share repurchases as a tool to inflate EPS and achieve compensation-related targets, and
4. Companies are notoriously bad at timing share repurchases, buying when flush with cash and share prices are high.

In the context of a global equity shareholder yield strategy, share buybacks are an important component of a company’s shareholder-value-maximising capital allocation process; share buybacks are simply one of the ways that a company can return excess cash flow to shareholders.

Whether that shareholder distribution takes the form of a cash dividend or a share repurchase program does not matter, although the value to shareholders of a cash dividend is obvious and tangible, while the value of a share repurchase is not quite as straightforward.

However, consider the following simple example: If you were one of ten partners who owned a business, and it was (mutually) decided to use free cash flow to buy out the interests of two partners, the remaining eight partners would end up each owning 1/8 of the business instead of 1/10.  Note: there has been no diminution of the business enterprise value because you did not sell off an asset to raise the cash to fund the repurchase of interests, you used free cash flow and nothing has happened to impair that collection of assets from generating future cash flows.

Good buybacks and bad buybacks

There are companies that add leverage – and therefore risk – to finance share buyback programs, and there may be management teams who are more interested in lining their own pockets than creating value for the owners of the business.  The important thing is to weed out the “bad” share buybacks from the “good” through careful and thorough analysis of each company.

As managers of a global equity shareholder yield strategy, Epoch Investment Partners emphasise the importance of analysis to ensure the management has considered share buybacks in the context of other strategies. Has the company’s management successfully identified high-return investment opportunities that enhance the value of the firm? Has the cash flow that has been returned to owners, in fact, been the highest and best use of that cash, or is their focus on short-term, self-enriching manipulation of EPS.

Epoch cites the 2014 share repurchase program of Herbalife, financed with debt and accompanied by the termination of the quarterly dividend, as an example of a share buyback program that failed to meet the definition of ‘value-enhancing’.

Return on capital vs. return of capital

In Epoch’s opinion, the related criticism that share repurchases frequently do not generate an attractive return on capital is based on a fundamental misconception. Studies have attempted to evaluate cash used to repurchase shares in the same way that cash is used to make a capital investment. While this seems to make some sense, it fails to distinguish between a return on capital and a return of capital.

When a company uses cash to, say, build a new manufacturing facility, it is appropriate and desirable to evaluate the return that the company earns on this capital investment. But, when a company uses free cash flow to retire shares, it is not somehow buying its own shares and holding them as an investment, hopefully earning a profit on its position. It is returning capital to the owners of the business.

A share of stock is evidence of an ownership interest; when the shares are repurchased and retired, the ownership interest is extinguished.

It is equally illogical to assert that stock price appreciation subsequent to a share repurchase program is evidence that the shares were undervalued at the time of the buyback and therefore management has succeeded with a value-enhancing repurchase, or that the failure of shares to appreciate following a buyback is proof that the share buyback was a mistake and not value-creative.

The best way to think about share buybacks, in Epoch’s view, is not that they will lead to subsequent share price appreciation, but that at the time of the repurchase, returning cash to the owners was simply the next best use of cash at that point in time.

A global equity shareholder yield strategy looks to invest in businesses that have proven themselves to be good capital allocators by investing free cash flow to fund high-return growth opportunities and by returning value to shareholders in the form of cash dividends and share repurchases.

The philosophy underpinning a global equity shareholder yield strategy sees dividends and share repurchases as equivalent ways of returning excess free cash flow to the owners of a business – in other words, to investors. As a result of such strategies, global equities can generate a reasonable level of income for investors.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Past performance is not a reliable indicator of future performance. Investing involves risk including loss of capital invested. ©2015 Grant Samuel Fund Services Limited.

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