The Life Cycle framework at the heart of our global equity investment process revolves around one thing – wealth creation. Companies create wealth by making an investment and earning a return above their cost of capital on that investment.
One of the questions we get a lot at the moment, given that these were previously a US-centric phenomenon before gaining more prominence globally in recent years, is what do we think of share buybacks?
Now the first thing to say is that, by the above definition, share buybacks do not create (or destroy) wealth. Despite being an investment that management make, it is an investment in the equity of the business, not the operating assets. What they instead do is reduce the size of the share count. This means that wealth creation, cashflows, profits, or whatever metric one looks at, is spread between fewer shares. The profits don’t increase, but the profit per share may. I use the word ‘may’, because there is an opportunity cost to profits from share buybacks. If shares are bought back out of excess cash, the business is sacrificing interest that could be earned. If debt is raised to buy back shares, the interest on that debt will decrease profits. With interest rates rising, these impacts are magnified.
It is worth highlighting that if companies can make wealth creating investments (i.e., investments which earn a return higher than the cost of capital) in our view it is almost always preferable that they do this, rather than buying back stock. Of course, many company’s investments are intended to be wealth creating but turn out to earn a return below the cost of capital. Management teams with strong capital allocation skills are key. For companies which sit in the early stages of the Life Cycle (Accelerators & Compounders) we see it as a potential negative in our wealth creation assessment if companies are buying back significant amounts of stock, since it is an indicator that they may be limited in their ability to reinvest cashflows, which is a sign of fade. For companies late on in their life cycle (Mature or Turnaround stocks), for whom most investments in their business would be wealth destructive, a share buyback or special dividend may reflect well on management’s capital allocation skills, as it shows they are aware of the company’s low return on investment profile.
When do share buybacks make sense?
Share buybacks are good when management buys back undervalued stock. Share buybacks are bad when they buy overvalued stock. In the latter scenario (with no other capital allocation options available), in our view the better decision would have been to return cash to shareholders in the form of a dividend. Some management teams understand this, many just see share buybacks as a return of cash to shareholders.
The most common cause of ‘bad buybacks’ is management teams outsourcing the decision to shareholders. ‘What would you like us to do with the excess cash?’ is on the surface a very reasonable question for management to ask their major shareholders. The problem is that it is rare to have a major active shareholder who does not think that the company, in which they have invested client’s money, is undervalued. You thus have a self-reinforcing spiral where management buy back stock at higher prices than the company’s future wealth creation warrants, the value of the company falls, and the management team refuses to take blame, saying it is what shareholders wanted.
As an example of share buybacks being used excellently in the last decade, Apple shines. At their 2012 results, Apple had 26.5m shares and a market cap of $627bn. By the time of their 2022 results, Apple’s market cap had grown to $2.4trn, but their share count had reduced to 16.3m shares. The value of the company had increased nearly four-fold, but thanks to share buybacks done at low share prices, the value of the company per share increased more than six-fold in that period.
Share buybacks are particularly interesting regarding certain late Life Cycle stocks at the moment. The supply chain bottle necks that occurred after 2020, allowed certain commoditised business models to generate unprecedented levels of cashflows. This allowed these businesses to reduce leverage significantly, or even entirely. The result is that these cyclical businesses are able to take advantage of ultra-low valuations at a point in the cycle when fear of recession is causing many of them to trade on trough valuations.
Take AP Moller Maersk, which generated just over $22bn of cashflow from operations in 2021, and just over $34bn in 2022. Its previous record cashflow from operations was around $10bn in 2010. This meant that, even after paying out a gargantuan $10bn to shareholders in the form of dividends, Maersk’s balance sheet has a net cash position of $7bn at the end of Q1 2023. Now because freight rates have fallen so sharply, and people fear what Maersk’s earnings will look like in the second half of 2023, then 2024 and beyond, the shares trade at a Holt Price to book ratio of 0.57x – an all-time low against an average of 0.82x in the last 15 years.
Typically, companies like Maersk would be much more concerned with their balance sheet and survival when seeing freight rates fall as rapidly as they have in the last 12 months. But Maersk can fully take advantage of this large net cash position and is currently undergoing a share buyback set in place for 2023, 2024 and 2025 of $3bn pa (versus a market cap of c$30bn), allowing them to reduce their share count by 30% in three years, assuming no move in share prices.
In a world where more money is driven by thematic trading, short-term macro trading, and passive Exchange Traded Funds, cyclical companies are well positioned to take advantage of being unloved in the short term, as investors flee for safe havens. It won’t be of surprise, therefore, to hear that Maersk is not alone in this front within the Royal London Global Equity Income Fund.
Steel Dynamics, the fund’s largest active holding, bought back a whopping 12% of its shares in 2022, and is continuing to buy at over 2% per quarter in 2023. Indeed, 20% of our holdings have bought back 5% or more of their shares in the last 12 months and nearly all of these are cyclical companies from the latter half of the Life Cycle (Slowing & Maturing, Mature or Turnaround). I often extol the virtues of a strong balance sheet for cyclical companies, the reason being that it gives so much strategic flexibility to management when a downturn does happen. I am generally referring to the ability to continue to invest in a business, service the debt and pay dividends without fear, but such is the position of these Covid winning sectors, that they may be able to continue buying back stock – even into the jaws of the long-awaited recession. Doing so at valuations which suggested terminal, not temporary, doom for the long-term wealth creation of these businesses could be a major driver of shareholder returns.
The Fund is a sub-fund of Royal London Equity Funds ICVC, an open ended investment company with variable capital with segregated liability between sub-funds, incorporated in England and Wales under registered number IC000807. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.com.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.