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14 April 2011

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Geoffrey F Ashby FCA

The worst example of monies wantonly thrown aeway is Wm Morrisons current buyback scheme where, over 2 years they are spending £1 billion despite active comments at AGMs and in writing from private shareholders - but Institutions unfortunatly vote in favour and swing the Voting. Morrisons Shares are 10p nominal which ,means that only about £30-40m is deducted from Share Cap[ital and the balance (£970m) from Revenue REserves - built up from excess Dividend Cover - EPS increases minutly but,as they are using increased borrowing interwst incurred wipes out any saving in Dividends payable on shares bought in. Net Assets drop by £1bn (forever). Shareholders will pay a second time because Dividend cover is set to continue around 2.5 times and will build Reserves back up and no doubt the Scheme will repeat - unless there is concerted action and the Chairman (Ian Gibson ex Northern Rock!) and Finance Director (Richard Pennycook) are replaced asap. Fund Managers need to voice their opinion at Meetings and vote against the proposed dividend - it is too little on basis the excess cover is being thrown away.

lostinmidlands

There is one externality that you don't seem to take into account, although the Feb 2011 FT article that you cite alludes to: the marginal income tax rate for investors is higher than the marginal capital gains tax rate. Isn't it used as an argument by managers (perhaps only implicitly?) to justify their policies of share buybacks?

This argument seems to have particular resonance for (very) wealthy investors: the gap between their marginal capital gains tax and income tax rates is higher and, unlike less wealthy investors, they cannot shelter a significant part of their investments from tax in ISAs or SIPPs.

Do you think that this is a significant factor in the trend for companies to favour share buybacks over paying dividends?

Geoffrey F Ashby FCA

The Wm Morrison buyback is a classic example of when NOT to buyback shares - and certainly not on borrowed money by a Company supposedly expanding and needing all the Funds and borrowing facilities it can lay it's hands on - what happens tomorrow when an unexpected opportunity arises?
I did'nt mention in my original comment that since so much money is spent acquiring so few shares it is a fact that the £1bn reduction in Net Worth is reflected in a fall in Net Assets per Share - at £2.80 purchase price per share and using 2010 Balance Sheet amounts this is definatly the case.
So, the Company has permanently virtually given away £1bn to no benefit to Shareholders, setting virtually all the outlay against Reserves built up from not paying higher Dividends but also, it will repay the money borrowed from Earnings retained in the future which could have augmented Dividends.
The terrible thing is that Institutional Shareholders are not bright/vigilant enough to spot this or Vote against nor attend AGMs to hear comments - result - we all suffer and cannot even make a few changes to Boards!

Jools

Are you saying that all share buybacks are bad? for example if a company has a significant net cash position and uses a portion of this to buy back some shares, which has the effect of soaking up some liquidity and reducing valuation multiples, which then has the effect of increasing the share price becuase it looks cheaper than competitors........where is the problem? the share price is up and the investor is better off, surely the result is better than the moral high ground.

Terry Smith

Jools,

No, I am not saying all share buybacks are bad. The problem is that if a company buys back shares when they are expensive, it destroys value for remaining shareholders. I am not referring to any short term share price movement but measures of intrinsic value. This problem is compounded by the fact that repurchased shares disappear from a company's balance sheet (along with the cash used to repurchase them) so it is difficult for shareholders to determine the impact of the buyback in terms of value creation or destruction.

Geoffrey Ashby FCA

I am shocked how such an easily grasped matter can be so clouded by people lost in a morass of ratios and non-feet on the ground thinking - it is very simply explained (in the case of Morrisons who are using borrowed money) as follows.
In simple book-keeping terms the first action when buying shares 'in the Market' is to Credit Loan Account and Debit Distributable Reserves - this reduces (permanently) Net Assets of the Company - because the Company has not acquired any tangible asset for the £1bn cost eg Not bought Land or a Company but it's own shares for cancellation.
So, what has the Company acquired? It has bought the stream of furure dividends which would otherwise have been paid to outside shareholders. Morrisons have been buying as high as 307p (so far) which is a return of about 3.2% based on the Dividend for the current year; against this are borrowing costs - and in future years (with UK bankrupt etc ) goodness knows how high they will be.
So, it is obvious that NO financial advantage has been gained, but there will be a several pence increase in EPS - immaterial because Dividends are covered around 2.5 times and an increase is not dependant on any plus from the Buy-out.
Using sheer Northern commonsense this ios not something one would do with one's own money. A company has certain basic parameters when considering Investment ( takeover of another Company, Investment in new branch etc) and this is a 5 year payback period ie 20% return on outlay - although this alters a bit dependant on prospects , Net Assets acquired etc. One can see that at present yields buying back shares at today's prices assumes a payback period of around 33 years ( 3%).
Some commentators and (sadly) analysts have been mislead by thinking shareholders were partaking in some sort of Capital Reduction scheme - NOT SO - we are looking at shares bought in the Market.
As a corollary, no doubt the Chairman will say at the AGM that the £1bn loan will be paid off out of 'Cash Flow' - sounds good? - you must be joking - Cash Flow means retained profits ie Dividends foregone.
As another example of Morrisons lack of thinking they have been touring around London, Edinburgh and New York - why on earth the latter - arte they looking to attract Bidders?! What evades their amateur hinking is that the Buyback considerably reduces Shares in Issue and clashes with trying to attract buying interest in what is purely a UK domestic company.
I hope this will provoke further thought and more down to earth comment.
It just remains for me to say that I started my career in the days of Clore, Wolfson, Jimmy Slater, Goldsmith etc - I would have been shown the door if I had proposed the Morrisons scheme.
If a company genuinly has surplus cash from for example, selling properties there are many capital reduction schemes actually returning te money (in a tax advantageous way) to Shareholders

Smokeless Wardance

Very topical - see Wood Group buying back fully one third of its shares on the cusp of a once-in-a-generation boom in oilfield services because John Wood wants to cash out.

Chris

The manipulation of equity is an art form mastered by management and ignored by investors and analysts. Buy-backs cannot be looked at in isolation from other equity transactions. For an overview that disproves numerous accepted truths see http://www.retailinvestor.org/truths.html

All in all, issuing MORE shares is better for the existing shareholder, as long as they are not spent to buy goodwill.

This has the effect of putting the capital gains (that would otherwise be realized in the secondary market) inside the corporation - where the marginal rate of return is larger than in the secondary market.

Chris

Regarding the author's proposed solutions for this problem .... IMO these ideas just increase the amount of disclosure, without adding any better understanding of 'what is happening'.

A more explanatory and short disclosure would be the reconciliation of book value per share proposed at http://www.retailinvestor.org/earnings.html This can be done with some degree of exactitude from the data disclosed already - although with some work. But that is was analysts are for, no?


Shareholder Equity, boy, adjusted
- Dividends
+/- Premium from Sh Issued/Redeemed
+ Comprehensive Profits
= Shareholder Equity, eoy, adjusted

Geoffrey Ashby FCA

Look at latest Accounts for Dunelm plc - they have just made a 'classic' buyback - capitalistion of 'B' shares and subsequent redemption.

Iain

The most irritating example that springs to mind is Next Plc with its forward purchase arrangements with banks like Goldman Sachs. The worst single day's effect I recall was the company paying around £7.8million (~30% premium) over the market price on two transactions. Better yet, there are limit protections for the banks against a rising share price, but none for the company against a falling share price. Its done wonders for the management's EPS targets and for the bankers, but shareholders and the company foot the bill.

Richard John

Isn't there also an element of driving up the share price by the company buying (back) shares in the market, (i.e. a demand for the shares) and thus doesn't that have the effect of increasing the value of investors holdings.

Terry Smith

Making a share price go up is not the same thing as creating value for shareholders. As a great man once said "Price is what you pay, value is what you get". There are countless examples of companies taking actions which inflate prices but destroy value, ultimately leading to their share price going lower than it started.

Geoffrey Ashby FCA

Terry's comment is so true. I was grateful to Mail on Sunday and Money Mail for printing the gist of what I had to say about the Morrisons Buyback Scheme. At the AGM there were no meaningful arguments from the Chairman in favour of their action versus my simple suggestion of creating Redeemable 'B' Shares and buying them back. Following Terry's argument - with my Shareholding I would have received about £50,000 versus nothing and a share price moving nowhere! If I wanted to move the Share price quickly and cheaply a Dividend increase of about 60% putting the shares on a 1.7 Cover would do it - the resulting yield plus low volatility,thrusting CEO etc.
What I find so depressing is that not just Fund Managers but qualified Accountants cannot these days see 'the Wood for the Trees' and, which is really alarming, nor can professional advisors (from Bradford experience!) The Company's answer seems to be 'we will look at it but it would be expensive'. I hope a few erudite Fund Managers and others will crystallise their thinking!

Bob Skinner

Geoff

Putting aside whether returning cash to shareholders adds value or not in general (which I agree is marginal at best), can you help me understand why you would prefer Morrisons to follow a redeemable B share route rather than straight market purchase and cancellation? They achieve the same outcome provided each shareholder participates proportinally in the company's market purchase programme.

In order words, if Morrisons were conducting a buyback equal to 5% of market cap, you could sell 5% of your shares and achieve the same result as a B-share scheme.

This way you could have received the £50,000 you imply you missed out on through the company not offering the B share scheme if you had sold £50,000 of your existing shares to the company through the market purchase scheme? Indeed, if receiving £50,000 was important to you, you should have sold £50,000 of shares regardless of whether you felt the share price at the time of the market purchase activity was fair not. If it was too high, you would have recieved more than market value for the shares you sold with this increase in value offset by a decline in value of the shares you kept arising from the fact that the company overpaid for the shares it repurchased, and vice versa, meaning the overall value of your holding is not dependent upon the share price you sell at.

Geoffrey Ashby FCA

Bob,
You raise a very interesting point and it has been known for a Compaqny to follow a Capital Reduction Scheme rather along the lines you suggest. I only refer to 'B' Redeemable Shares because this is the generally recognised term for such schemes and vMorrisons has sufficient Distributable Reserves to carry it out.
The overall point which applies is that ALL Shareholders receive cash benefit pro rata to their share holdings and that after completion their individual shareholdings retain their individual percenta ge relationship to the total shares in issue - and, by and large, the value of their individual holdings after the scheme equals the value before the scheme.
Buying back shares involves debiting (charging ) Distributable Reserves and increasing Borrowings - Reserves were built up from Dividends forgone in previous years and clearly belong to ALL Shareholders. Clearly, to make Market Purchases from unknown (at the time) shareholders does nothing special for them ( they could anyway have sold ) and nothing for the rest of us (ignore several pence increase in EPS).
Taking your suggestion, a company could announce that an offer was to be made at a given price (probably market price ruling at a set day plus a percentage) for a stated percentage of EACH Shareholders holding.
At completion, each shareholder would have received cash commensurate with his holding and be left with a reduced number of shares BUT because the remaining shares would then have a proportionate increase in EPS and dividend and cover they would undoubtedly have a combined market value equal to the value of the original holding before the swchem.
THat is obviously in simplistic terms but shows my point that I expect ALL shareholders to benefit/partake in the paying away of our accumulated reserves. Equally well, the same thing could be achieved by Morrisons by paying one or more supplementary dividends.
I hope you now understand my point - use of the Scheme 'B' route is very tax efficient compared with the dividend route.
Please revert if I have failed to help.

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