Shareholders should question the rationale for share buybacks

IN HIS 2023 State of the Union address, US President Joe Biden proposed quadrupling the tax on corporate share buybacks to 4 per cent “to encourage long-term investments’’.

Explaining the rationale for the move, national economic adviser Lael Brainard said the tax “will encourage companies to invest in workers and the US economy, rather than paying out stock buybacks to wealthy investors”.

However, famed US investor Warren Buffett – obviously one of the “wealthy investors” – said in his 2023 letter to shareholders that anyone who criticised stock repurchases is “either an economic illiterate or a silver-tongued demagogue”.

Clearly, then, buybacks are a controversial corporate activity. Given their rising popularity – in 2023, 69 Singapore Exchange primary-listed companies bought back shares totalling S$743 million while the figures for 2022 and 2021 are even more impressive at S$1.69 billion and S$1.19 billion, respectively – it’s worth asking: What exactly is the justification for a company buying back its shares?

One popular argument is that by cancelling bought-back shares and therefore reducing the number in issue, if all things remain equal, the same earnings spread out over fewer shares would mean higher earnings per share (EPS), which should then boost the share price.

It is true that as long as earnings fall by less (in percentage terms) than the percentage of shares outstanding, EPS will rise. And if we assume that the market sets prices by simply and mechanically capitalising reported EPS at industry-wide multiples, then stock prices will go up.

However, if this were the case – when taken to the logical if ridiculous extreme – buying back all shares and bringing the number of shares down to zero would result in EPS being boosted to infinity!

Furthermore, using EPS or the related metric of the industry’s price-to-earnings ratio is only one of many ways the market uses to set prices. To expect a decrease in the number of shares to automatically push up share prices is overly simplistic, to say the least.

Another popular argument is signalling, where management – as insiders who possess superior information – uses buybacks to signal good news about future profitability that is not reflected in current prices.

Managers are thought to be willing to commit to high cash payments today because they expect that future capital needs can be financed with anticipated increases in future earnings.

However, empirical support for this reasoning is inconclusive. While some studies found modest evidence of earnings growth depending on the mode employed when performing buybacks, at least one found a decline in operating income as a percentage of total assets. (See The Information Content of Share Repurchase Programmes by Gustavo Grullon and Roni Michaely, published in April 2004 in Journal of Finance.).

In the local context, the findings of a study conducted on buybacks by listed companies in Singapore, Malaysia and Hong Kong between Jan 1, 2010, and Dec 31, 2022, by Mak Yuen Teen and Tan Yi Jie are interesting.

It found that, on average, there is no relationship between the amount spent on buybacks and shareholder returns over periods of one to three years following the buybacks, and, if anything, shareholder returns tend to decline.

Perhaps the best that can be said is that shareholders who are asked to endorse a buyback mandate should recognise that rigorous theoretical or empirical justifications for the activity are difficult to come by; as such, they should subject repurchase proposals to greater scrutiny before granting approval.