Share buybacks send important signals

The case for a company buying back its own shares is clear enough. If the shareholders can expect to earn more from the cash they could receive for their shares than the company can expect to earn by reinvesting the cash on their behalf, the excess cash is best paid away.

Growing companies have good use for the free cash flows they generate from profitable operations. That is to invest the cash in additional projects undertaken by the company that can be expected by managers to return more than the true cost of the cash.

This cost, the opportunity cost of this cash, is the return to be expected by shareholders when investing in other companies. Such expected returns, a compound of share price gains and cash returned, are often described as the cost of capital. And firms can hope to add wealth for their shareholders when the internal rate of return realised by the company from its investment decisions exceeds the required returns of shareholders.

All firms, the great and not-so-good, will be valued to provide an expected market-competing rate of return for their shareholders. Those companies that are expected to become even more profitable become more expensive and the share prices of the also-rans decline to provide comparable returns. How then can a buyback programme add to the share market value of a company?

Perhaps all other considerations remaining the same — including the state of the share market — the share price should improve in proportion to the reduced number of shares in issue. But far more important could be the signalling effect of the buybacks. Giving cash back to shareholders, especially when it comes as a surprise, will indicate that the managers of the company are more likely to take their capital-allocating responsibilities to shareholders seriously.

The case of Reinet (RNI) the investment holding company closely controlled by Johann Rupert is apposite. Rupert believes the significant value of the shares bought back by Reinet has been “cheap” because they cost less than their book value or net asset value (NAV). Yet the market value of Reinet still stands at a discount to the value of its different parts and may continue to do so.

First, shareholders will discount the share price for the considerable fees and costs levied on them by management. Second, they may believe the unlisted assets of Reinet may be generously valued in the books of RNI, so further reducing the sum of parts valuation suggested by the company. Third, the market price of RNI has been reduced because the returns realised by the investment programme of RNI may not be expected to beat their cost of capital and will remain a drag on profits and return on capital. So the value of the holding company shares is written down — to provide market-competing, cost of capital equalling, expected returns — at lower initial share prices.

Yet for all that, the shares bought back may prove to be cheap should Reinet further surprise the market with more improvements in its ability to allocate capital. And the gap between NAV and market value could narrow further because the value of its listed assets declines.

Indeed, shareholders should be particularly grateful for the recent performance of RNI compared with the value of its holding in British American Tobacco (BTI), its largest listed investment. RNI outperformed BTI 50% this year. Unbundling its BTI shares — an act normally very helpful in adding value for shareholders because it eliminates a holding company discount attached to such assets — would have done shareholders in RNI no favours at all this year. 

The reason many SA companies are buying back shares on an increasing scale is the general lack of opportunities they have to invest locally with the cash at their disposal, for want of growth in the demand for their goods and services for all the obvious reasons. Yet the reluctance to invest in SA makes realising faster growth ever more difficult. That the cash released to pension funds and their like will increasingly be invested in the growth companies of the world, rather than in SA business, is the burden of a poorly performing economy that South Africans have to bear.

This article originally appeared on BD Live