Share buybacks: what you need to know

They aren't always a buy signal and investors should bet on the big picture, explains Morningstar Investment Management's Michael Keaveney

Michael Keaveney 13 August, 2019 | 1:45AM
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Michael Keaveney: Share repurchases, or buybacks occur when a company reacquires some of its own shares. Buybacks are one way a company can allocate its capital alongside paying out dividends, paying off debt, investing in current operations, or even entering new businesses.

Buybacks have increased in popularity since the 1980s, when regulatory rules made it easier for firms to buy back their own shares without fearing charges of market manipulation. There were record levels of buybacks in Canada and in the U.S. in 2018, and the torrid pace continues this year. In fact, the amount of money large U.S. companies spend on buybacks now regularly exceeds what they pay out in dividends.

A retail investor who continues to hold the shares of a company that is actively buying back its own shares from other investors ends up owning a larger proportion of the overall company than they did before and therefore has proportionately bigger claim on future profits. But potential investors shouldn't take an announcement that a company plans to buy back shares as a surefire buy signal.

First, companies may not end up repurchasing all the shares they intend to over a given period.

Second, it's necessary to determine if the company is going to be buying back shares at reasonable valuations and that the company is making good use of cash available versus other opportunities, and not taking on unnecessary debt to finance repurchases.

As share repurchases and dividends are both potential uses of company capital, dividend-focused investors might worry that a buyback strategy will constrain dividend payments. This is technically true in that the same dollar of capital can't be deployed twice. It's also fair to say that investors in general and dividend investors in particular prefer the certainty of a dividend to a somewhat less than certain capital gain, all other things being equal. However, companies pursuing a wise allocation strategy can reserve a sustainable amount of capital for dividend payouts which investors expect to be regular, and amounts above that for share repurchases, which are less likely to be perceived as bad if the amount fluctuates. Buybacks also allow for some company flexibility, and depending on the jurisdiction and type of investor, may have more favorable or flexible consequences than a dividend payout.

At Morningstar Investment Management, we believe investors should look beyond the headline dividend yield to how sustainable the dividends and growth of dividends are and the total payouts, which include the effects of share repurchases. Share repurchases can be part of a company's prudent capital allocation strategy, and investors should consider the net effect of those purchases alongside any dividends paid. Indeed, in the long run, our research indicates that the cash flows that corporations supply, including payouts in the form of buybacks as well as dividends, are the ultimate drivers of stock returns.

From Morningstar Investment Management, I'm Michael Keaveney.

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Michael Keaveney

Michael Keaveney  Michael Keaveney, CFA, is Director, Investment Management at Morningstar Associates, Inc.

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