The case against share buybacks 1 comments

DanielXX's intro: Below is an illuminating writeup on a market investor's experiences with share buybacks on the Singapore stock market, and why he disapproves of them. It is a strong argument against share buyback mandates given the potential for abuse by insiders.

(P.S: The following were extracted from another source and is not my original work.)

Share buybacks are indeed controversial. I wish to offer the following observations regarding on-market share buybacks.

It is well known that companies sometimes overpay in their share buybacks. Some may then sit out long periods of lower prices without further buybacks. It is doubtful if such buybacks really contribute to shareholder value.

Companies often have share option schemes alongside share buybacks. Some executives may also be selling shares while the company carries out share buybacks. In particular, off-market share buybacks normally allow for a premium of 5-10 per cent over the prevailing market prices.

Investors thus need to be convinced that buybacks are not used to boost the share prices such that executives profit from their share options. Investors' suspicion will be further heightened if, as is quite often the case, independent directors are also eligible for share options.

Sustained share buybacks can eventually result in a measurable increase in the controlling shareholders' stake in a company. This is advantageous to them as the gain is acquired using the company's cash, not their own. Further, if the controlling shareholders are also eligible for share options, the stake may rise even faster.

Despite having substantial Section 44 tax credits, some companies show obvious preference for share buybacks over special cash dividends in capital management. The tax credits will benefit the shareholders only if distributed with dividends to them before Dec 31, 2007. As such, these companies need to explain clearly why special cash dividends - which are also cheaper and speedier to effect than share buybacks - are not preferred.

Companies will want investors to believe that share buybacks add value to their shares through improved financial ratios, including earnings per share (EPS) and return on equity (ROE). The irony is, CEOs and senior executives are also normally further rewarded upon such EPS and ROE improvements. Besides, such improvements are 'bought' with the company's cash and so are not 'performance' per se. Investors once again wonder, and legitimately so, if the buybacks are instituted primarily for the executives' benefit.

Discerning investors know also that for any given amount of cash earmarked for a payout, companies can just as easily deliver the same ROE impact - with Section 44 tax credits, if available, in tow - via a cash dividend distribution. As well, they know that if a company earns $10 million a year, its market capitalisation will be $100 million at a given time on a given price-earnings ratio of 10, whatever the number of shares it may have in issue. That is, the effect on its market capitalisation of a higher share price 'bought' on an improved EPS will have been cancelled out by that of the number of shares it so manages to take off the market via the same share buybacks.

Thus, the EPS and ROE benefits much heaped on share buybacks are not much more than an illusion after all. (Readers will want to note that these comments on EPS and ROE apply equally to capital reduction schemes which often are used either independently of or together with share buybacks by companies for their capital management.)

I believe companies should have policies to explicitly disqualify the undeserved 'performance' associated with share buybacks from executive pay computation.

(The above was extracted from a certain Kenneth Pang's letter to the Business Times forum dtd 28 Jun 06, without his permission, so thanks anyway Kenneth, and forgive me for my trespasses.