Further Discussion On Share Buybacks

A reader, who also has a decent business blog, made comments on share buyback. They deserve some discussion.

AhYap.com has left a new comment on your post "Share Buybacks Revisited":

I thought--

Treasury shares (shares bought back by company) are not not included when calculating the non diluted eps. So the eps will increase. And because treasury shares are not subjected to dividend, dividend to shareholders are suppose to increase.
(Its not that they do not get the dividends, they do, its just that the dividends go straight back to the coffers, so you cannot argue that they are not subjected to dividends).

Share buy back allows company to control market price if it is too undervalue, or in the US when market price is attached by short sellers making fake news.
(There are no short selling in Malaysia, so why go on share buyback then. In the US, too much emphasis is paid to share price as a CEO's compensation and bonus are usually tied to share price movements, hence they have more propensity to boost share price by doing buybacks and canceling the shares. To me, that is short sighted as the CEO only wants to move share price but usually at the expense of investing excess funds for the long term. Your argument on short selling does not make sense as short sellers would not target an undervalued counter).



Stocks that has been bought back can be distributed back to shareholders and immediately increasing shareholder value because each shareholders now own more of the company.
(I agree).

Buying back shares is the same as paying back dividends in some sense. Buying back shares is more meaningful if the share is believed to be undervalue. But a shareholder who think the stock is undervalue and receive cash dividend can easily repurchase the stock in the open market.
(Management is paid to run a company, to grow it. If you have access funds and you do not know what else to do with it, then give it back to shareholders, let the shareholders decide what to do with the funds because the management obviously has no better ideas. You cannot just simply buyback shares because you think its undervalued - my thesis is that management has to work harder to make the money work and not take the easy way out).



Different is if company buy back shares, it send out strong signals to the market on what management think about the stock price. And company share buy back has bigger volume to support share price as compared with individual shareholder who try to buy with their cash dividend.
(Wrong again, look at the number of companies that have been buying back shares, the whole perception of the company has not really changed, except for a select few. Look at Mulpha, Bolton, Ebworx, Lien Hoe, Degem, Dialog, Eng Teknologi, Brem Holdings, Integrated Logistics, Ralco, Rexit, Sunchirin, VSI, Tekala .... how has it improved perception???? The few that have done so, successfully, are few in between, Delloyd, QL, Mudajaya, MFCB, Latexx and MTD Capital. What I am getting at is too many of them are not addressing deeper problems within, and always just blame the market for undervaluing them).

Cancellation of treasury shares are not a wise move for small cap companies that need liquidity. It is wiser to distribute to shareholders. Big companies are welcome to cancel shares.
(If you need liquidity, why buyback shares in the first place??? Why reduce free float of your already small cap???)

Even if treasury shares are not canceled, selling them when the market price is higher will make company money and increasing shareholder value.
(This is very bad management. They are paid to run the business, not to trade in their own shares. Even if they make a profit, any analyst worth their salt will ignore the gains because its non recurring and exceptional. No matter how you cut it, trading in your own shares should never be part of your business model).

Those shares can also be used for acquisition without the need to issue new shares that will dilute shareholders value.

The treasury shares can also be sell in bulk to potential institution investors that need a big volume that buying in market is difficult.
(This I agree totally).

I have full support for share buy backs.

(Again, I stress that I am not against share buybacks, I am against management NOT addressing deeper issues within the company. A company does not stay undervalued if they do all the right things, they ......
need to ask themselves more questions as to why their share price is not at a level where it should be – are investors not happy with the management’s vision; is the company not communicating its plans effectively; has the company not been able to chart a credible track record; have the financial results for the company been haphazard or inconsistent; is the company too unfocused or too diverse that nobody even wants to follow/research the company; how is the management track record been in treating minority shareholders; have transactions or deals been really fair to all shareholders or been forced down investors’ throat (oops, getting too specific here) – chances are the stock will be rated properly if the above concerns have been addressed. Hence most share buybacks will not be entirely successful as it is fighting against the “enemy” when the “enemy” is really internal not and not external).

Share Buybacks Revisited

There was an opinion article in StarBiz today on share buybacks. In its premise, there is one major error. Did you spot it?

StarBiz - "Under normal circumstances, investors should get excited when companies buy back their own shares. In theory, this action implies the management views the best available investment opportunity for the utilisation of excess cash is to invest in its own company rather than buy into some other companies.

This is because when a company buys back its own shares, it will reduce the firm’s outstanding shares and enhance the company’s earnings per share (EPS).

Due to information asymmetry, the management is in the best position to determine that the company is being undervalued at the current price and, thus, it is to the best interest of the shareholders to buy back the company’s shares.

Hence, in general, we can conclude share buybacks usually convey a positive signal that implies the stock of a company is underpriced."

Share buybacks on its own does not reduce the firm's outstanding shares because they are not canceled. The shares outstanding remain the same whether a company buys them back or not. Hence, it is also true that share buybacks does not enhance the company's EPS as well. Considering that 99% of all Malaysian listed company share buybacks do not result in shares cancelation but are kept as Treasury shares - there is NO improvement in EPS.

What should investors’ opinion be of these share buybacks? Should companies make known their intentions?

We need to understand first why there is a stockmarket in the first place? First and foremost, it is there to allow companies to raise cheap funds to fund their growth strategies. Secondly, it is to allow for individuals and other entities to participate in the growth of these companies. Other reasons are secondary in nature. A company raises funds to facilitate corporate strategies, hopefully they will make money, preferably higher than the prevailing interest rate (if not, all funds should put money in the bank and close shop). Successful companies may keep accumulating profits to prepare itself for two general reasons: market down cycles, or in order to take advantage of opportunities when there is a market/industry correction/sell-down.

Companies should only indulge in share buybacks when accumulated funds are in excess for the above two reasons. This is because share buybacks will deplete reserves and may not be easily convertible to cash when there is a downcycle or market correction – the time when funds may be needed for those two purposes. Companies doing share buybacks must and should consider this aspect before embarking on the said exercise. Even then, the company can still decide on other options to do with the excess cash – give back to shareholders in the form of dividends or bonus – especially in a matured industry.

Companies raise cash for investing in growth, if they find no good investing opportunities after a prolonged period and cash flow is healthy, the funds should be returned to shareholders. Companies doing share buybacks are basically saying that that is the best way to spend their excess cash. To arrive at that decision, they must be convinced that their share is undervalued compared to their company's prospects. A company’s share price may not reflect its true potential – who knows the company’s fundamentals better than the people running them.

Then we have to look at why management is doing this – is it to improve share price via reducing the free float; and/or improve the earnings per share (but that only happens when they cancel the shares). If a company has to resort to improving their share price by reducing free float, it is usually not successful – a simple glance at the past 2 years' price performance of most of these companies will tell you that. By reducing free float, it is a futile exercise as the company will have to accumulate a significant amount to prop up the share price – that seems artificial no matter how you look at it as the only group really keen to own the shares is the company themselves.

Of course, share buybacks can successfully engineer higher share prices by massively reducing free float but they will have to meet regulations for minimum free float in the market place. The danger is that share buybacks can be taken advantage as “insider trading” by management as it involves market timing – hence the authorities must be more vigilant when it comes to the timing of share buybacks. If a company buyback the shares and do not cancel them, are they waiting to unload when price is higher? That is tantamount to trading in their own shares or having an investment portfolio. Is that part of the company’s normal course of business? Can this activity account for a substantial amount of profit for the company? How should analysts regard this profit – probably not enthusiastically as it is considered as a “one-off.”

It is safe to say that companies should make their intention known to the public when doing share buybacks – is it for future placements to institutions; to be canceled, if so please state a time frame; not to be canceled, but to be sold back into the market when price is higher; or to be disbursed as bonus. To me, that is vital information and I believe investors will rate the stock accordingly with the new information.

Bottom line, if it is not going to be canceled, share buybacks are not really that big a positive in rating the company. Most times, companies who do share buybacks will not see significant improvements in their share price – investors do not rate a company higher because of that as investors are not buying the stock in the first place for various other reasons, and the freefloat is not really a major reason. Any worthy share buyback has to be canceled for it to be effective.

Companies not doing that, need to ask themselves more questions as to why their share price is not at a level where it should be – are investors not happy with the management’s vision; is the company not communicating its plans effectively; has the company not been able to chart a credible track record; have the financial results for the company been haphazard or inconsistent; is the company too unfocused or too diverse that nobody even wants to follow/research the company; how is the management track record been in treating minority shareholders; have transactions or deals been really fair to all shareholders or been forced down investors’ throat (oops, getting too specific here) – chances are the stock will be rated properly if the above concerns have been addressed. Hence most share buybacks will not be entirely successful as it is fighting against the “enemy” when the “enemy” is really internal not and not external.

Wall Street Bonuses Needs A Revamp

I kept quiet when anger was spilling all over the streets over the millions of bonuses paid to some AIG executives. Technically, the guys (they were all guys) were entitled to the bonuses because it was written in their contracts. The new CEO had no choice but to honour those contracts. However, there are also a legal and an ethical side to the issue. AIG has had to take so much money from American taxpayers in order to stay afloat. If the American taxpayers did not fund the bailout, there would be no AIG and these executives would never ever see a cent of their so called contractual bonuses. You sign a contractual bonus to protect yourselves from uncertainty. In that sense there may be some credence to them getting the bonuses. It is precisely from these kind of fallouts which causes the executives to sign those bonuses. Realistically, many of those who got the bonuses were not part of the unit which got AIG into trouble, most of those have left the building already - those ones responsible for creating and selling Credit Default Swaps on the CDOs.

The public isn't really angry about greed on Wall street, thats a given, greed is Wall Street. The public's anger is you shouldn't get bonuses for doing a shitty job. People are losing their jobs because of the financial crisis brought on by the "bad things on Wall Street", they are seeing their home values being decimated because of that, they are seeing their retirement fund being wiped out by half because of that ... and you still want your bonuses??!!!

Now its confirmed that these AIG bonuses would be taxed at 90%. That was a popular new law which was put in place to clawback the sums paid out. The ramifications from all this is that the banks who also took TARP and other government money may find themselves in similar hot water should they also pay out exorbitant options and bonuses. Thats why Goldman Sachs and a few others have come out to address the "new compensation scheme" for its bankers. Many of the banks new scheme basically puts most of the bonuses in the form of options and may only vest after a certain period, usually 3 years. There will also be clawback clauses which means that options may be taken back if future years see a huge dip in profits before they vest.

Bank of America and Citigroup are a bit stupid when the CEOs said that they may be raising the senior executives salary packages to compensate for the fact that they will only receive mostly share options that will take longer to vest as bonuses instead of cash. That is a slap in the face of what the spirit of the "new compensation scheme" is trying to achieve. They are just trying to find a way around the new paradigm, not working with the new paradigm.

I have argued in previous postings that there has to be a new way of determining compensation. The whole shebang in tying in senior executives compensation to "share price performance" only is flawed. This cause instructions and strategy from the top to MAXIMISE profits on limited deployment of capital. It encourages excessive risk taking to rake in profits - bankers would bet with 10x leverage on capital on market direction and will stand to collect when it turns out well, but if it goes the other way, hey, I will resign and look for another firm to ply my trade. There is no real punishment for mistakes on huge bets but there is great rewards for guessing correctly.

The mistake in linking bonuses only to share price compensation also result in management to immediately use any positive cashflow to buyback shares, as this would enhance eps and thus boost share prices. As their share options will rise in value when the share price move higher, management will be quick to do share buybacks. You can go through a number of research papers and they will confirm that companies doing share buybacks always under perform the rest of the market. Buying back shares may not be the most prudent thing to do. Management has to be incentivised in planning for longer term, and to make acquisitions and disposals to sustain their market share growth - all of which requires a more diligent use of cash flow and capital. Many of the banks are in trouble now because of their wafer thin capital adequacy. In good times when they raked in profits, most of it was sent to buyback shares. Now that they need to have more capital, they are forced to sell lucrative assets and/or sell more new shares at very depressed prices - both kicking the minority shareholders interest in the face.

My view is that an executive's compensation and bonus should be tied to a matrix of:
a) share price performance
b) eps enhancement
c) prudent returns based on capital deployed
d) making sure the company stay within defined boundaries of acceptable leverage, debt ratio and debt servicing
e) allowing management to only buyback a maximum of 2% of outstanding shares a year
f) the bulk of the bonuses should be based on a review every 3 years on how well management has planned and execute their longer term strategy in ensuring market share growth

We basically need to reduce substantially the quantum of bonuses paid out annually, and move to a bigger sum being based on a 3 or 5 year period. It encourages longer term planning, less shuffling of assets, less misuse of cash reserves.

What I lost last year . .

p/s photos: Angelababy (yes, that's her name, what a marketing coup)

Regulators Need To Fix Dividend & Share Buyback Schemes

Possibly my most important posting this year.... This is not the crux of the problem we are facing but is part and parcel of navigating the "compensation culture" of Wall Street and high-falutin' CEOs. Excessive risk taking has been the center of what brought the credit markets to its knees. The compensation culture is one where the base salary is only a fraction of these people's compensation packages, even though for many of them the base salary is already more than $1m. In Wall street, the culture is even more evident in that analysts and bankers get between $100,000-300,000 as their base salaries but there is a tacit understanding that their overall compensation will be in multiples of their base salary - and not in number of months like the rest of us. Hence many of them argue that the compensation cap by Obama will not work. Its like saying "don't throw us in prison as there are too many of us"...

An article by David Reilly, Bloomberg news columnist, wrote recently that there need to be a revamp of the way companies pay dividends and do share buybacks. I totally agree. Dividends that are steady, predictable and "high-ish" will always attract the longer term funds as solid shareholders, thus propping up share prices. As the CEO, your destiny is tied to the share price, thanks to the finance literature over the last 20 years which says that the CEO and senior management's goals, objectives and compensation must be tied to the share price performance - which indirectly implies that shareholders interest are served. BUT ARE SHAREHOLDERS INTERESTS BEING SERVED PROPERLY?

The compensation maniac rise over the last 10 years and the current crisis basically reinforced to us that shareholders interests are not best served under current system of tying in share prices to compensation.

The current system will make almost all CEOs to aggressively pay out strong dividends or have a strong dividend policy, and worse still, engage in frequent and at times excessive share buybacks. Share buybacks in the US are usually then canceled (unlike in Malaysia, which defeats the purpose) and that will improve the EPS by a corresponding amount, which will then move share prices higher if forward PER ratings and valuations stay the same. That is because the bulk of the CEOs and Wall Street compensation rides on share options.

The danger with Obama's pay cap is that much of the additional compensation will be paid via shares, although they will only vest after TARP money has been fully repaid. Thus, I can already predict what the CEOs will be doing once they get profits rolling again:
a) pay down TARP
b) improve dividends
c) buyback shares
The only difference is that they will pay down TARP as a new priority. It does not change the compensation culture. Especially in times like this any free cash flow should be used to shore up balance sheet and increase your capital standing and sufficiency, not paid back via dividends or doing useless share buybacks.

I can soften the blow for dividends, its good and essential to encourage long term shareholders to hold onto good stocks for a long time. I do agree that if a company can, they should pay good dividends, above the company's capital requirements for normal growth strategy. It would be prudent to have a proper dividend policy (e.g. percentage of profits that goes into dividend pool; or targeting a dividend yield year in year out). But do not do haphazard dividend payments one year from the next, it is unprofessional and unpredictable, and will cause valuations to be marked down.

Here is where we need more bite from the board of directors, especially the independent ones. New guidelines by the SEC should be furnished to the directors to ensure that dividends and share buybacks are backed by a solid grasp of business fundamentals and industry trends.

Share buybacks are only OK if shares are subsequently canceled, otherwise the CEOs have no fucking idea what share buybacks are supposed to do. Trashing share buybacks was my very first article for this blog, so its ranks very high on my list of piss-me-off-silly issues. However, owing to the compensation culture in Wall Street and among CEOs in the US, the share price is like their religion. Thus they will engage in excessive and frequent share buybacks, EVEN when they are not necessary - this will lead to a depletion of capital, and hello... what are really troubling the banks nowadays.... They have pushing a lot of free cash flow into share buybacks, depleting capital, pushing up EPS... and yet leveraged up even more on their remaining lesser capital.

Now, oops, they need more capital... We need a regulatory body to oversee the amount of shares each company is buying back and reassess them as normal capital requirements for the companies in those industry. For example, between 2003 and 2007, Citigroup paid out $44bn in dividends and spent $22bn buying back stocks. If they had slashed their dividends by half and not do any share buybacks, they would have an additional "capital" of $44bn. But noooo... the compensation culture is such that every time these buggers see some money flowing into the coffers, they will think of ways to use them immediately, always running on the edge, skirting between raindrops... maximising every dollar. Capital is there for a reason, ... to fund growth , AND TO HELP THE COMPANY RIDE OUT BUSINESS CYCLES & MAYBE CATACLYSMIC RECESSIONS.

Is there anybody out there???

p/s photos: JJ