Share Buybacks : Always Good News?

Banish Fear (of) Markets - Issue 12/2022 - 29 March 2022

Markets generally went sideways last week. But Alibaba was a stand-out after it announced a massive share buy-back programme, giving itself the authority to buy back US$25 billion of its own shares. Its shares rose 13% on the news. Even shares of its rival Tencent rose in anticipation that Tencent might announce a similar share buyback programme as well.

Why are share buybacks usually received as good news by the markets?

At a fundamental level, it’s maths. When a company buys back its shares, the shares it buys are taken out of circulation. So the same profit cake is now shared between less shares. So each share is entitled to a larger slice of profit, and therefore is valued higher than before.

But share buybacks are also a signal by the company that it views its own share price as undervalued given its current business conditions and future prospects. Let’s not forget, the company management is the ultimate insider: It has the most immediate information on its current operating conditions and future prospects. Even the stock market, which receives company financial updates only every quarter (barring major news) is behind the curve. So when a company starts to buy back its shares, it must feel its prospects more than justify its prevailing share price, and so investors are comforted and the company’s share price rises in tandem.

In 2021, Apple spent $85 billion in share buybacks, Berkshire Hathaway US$21 billion. Microsoft US$23 billion.

But why do share buy backs instead of dividends?

In the US, it’s about taxes. Dividend payments are immediately taxed, but share buy backs are only taxed when, as a US national, you sell the shares and make the capital gain.

The other reason is flexibility to the company. Companies have more room to decide exactly when to purchase their own shares. Dividends are a bit more rigid. Institutional investors do not like to see volatility in dividend payments, so companies tend to not change their dividend pay-out rates from year to year.

For investors too, the certainty of a dividend payment is sometimes preferable. Imagine a company uses its cash to do a share buy back instead of a dividend payout. Then a week later war breaks out and the stock price tanks. You would have been better off having the dividends.

As a non-US person investing in US securities, I prefer stock buybacks to dividends any day. Reason? Dividends are subject to a whopping withholding tax of 30% for non-US nationals. In contrast, gains from sale of shares does not attract any capital gains tax for foreigners.

Are stock buybacks always good news?

Well, we have a local example of a stock buyback that went horribly wrong.

Between Oct 2020 and Feb 2021, Top Glove spent RM1.42 billion buying back 200.17 million shares of its own shares in the price range of RM5.78 to RM8.01. This works out to an average cost of RM7.09 per share.

Top Gloves shares closed yesterday at RM1.72. So the shares are now worth RM345 million. So that’s a whopping RM1.07 billion loss, which could instead have been returned to shareholders in the form of dividends.

In Top Glove’s case, company insiders got it very wrong about their own company’s prospects and risks. Indeed, the latest numbers they reported two weeks ago showed how wrong they got it. For the 6 months ended Feb 2022, Top Glove’s? revenue slumped 70% from RM10.1 billion to RM3 billion, whilst? net profit plunged 95% from RM5.2 billion to RM273? million compared to a year ago.

Yes, successful share buybacks also depend on the company’s management not drinking their own Kool-Aid.