Share buybacks: a beautiful thing

[mc2fool]

The beauty is that you can withdraw 5% annually for 20 years without paying any tax as this 5% is considered return of capital.

You can withdraw 5% annually for 20 years of the amount you have invested without paying any tax.

In other words you can get back out 100% of the amount you put in free of tax!

Why on earth is this "the beauty" of it, and how is this a tax advantage?!?

[BusyBumbleBee]

The beauty is that you can withdraw 5% annually for 20 years without paying any tax as this 5% is considered return of capital.

You can withdraw 5% annually for 20 years of the amount you have invested without paying any tax.
In other words you can get back out 100% of the amount you put in free of tax!
Why on earth is this "the beauty" of it, and how is this a tax advantage?!?

Your Points 1 and 2 are quite correct mc2fool,

The tax advantage is this :

Under current tax rules you won’t have to pay basic rate income tax or capital gains tax on your Flexibond.

so these are commonly used to defer withdrawals (apart from the return of capital) until your income is within the basic rate band. i.e when a huge chunk of your income is coming from tax sheltered pots.

Not for everyone - but everyone should be aware that they exist and of the advantages (and disadvantages) and do their own research bearing in mind their own circumstances including age, marital status and likely pension income.

[mc2fool]

The tax advantage is this :

Under current tax rules you won’t have to pay basic rate income tax or capital gains tax on your Flexibond.

Yes, but that's because: https://www.nfumutual.co.uk/globalassets/investments/bonds/flexibond/nfu-mutual-flexibond-key-features.pdf

NFU Mutual pays tax on income and capital gains within the funds. Non tax payers can’t reclaim this.

In other words, you aren't paying tax 'cos the scheme has -- and this will reduce returns of course. This is unlike the no-tax-at-all situation of holding funds in an ISA.

As you say, these are really tax deferral structures, primarily for higher/additional rate taxpayers who expect to become basic rate taxpayers in later years.

[mc2fool]

BTW, there are also offshore versions of these (IoM & Lux) which still have the 5% for 20 years feature but have the advantage of having no tax within them (so like holding funds in an ISA), but then the disadvantage that withdrawals beyond the return of capital are taxed at your marginal rate of income tax (inc. basic).

At least that was the way it was when I had one many yonks ago. I gave mine up 'cos in the end I figured it wasn't going to be particularly advantageous -- except to the provider, via charges!

[Lootman]

BTW, there are also offshore versions of these (IoM & Lux) which still have the 5% for 20 years feature but have the advantage of having no tax within them (so like holding funds in an ISA), but then the disadvantage that withdrawals beyond the return of capital are taxed at your marginal rate of income tax (inc. basic).

At least that was the way it was when I had one many yonks ago. I gave mine up 'cos in the end I figured it wasn't going to be particularly advantageous -- except to the provider, via charges!

Yes, I looked into these products as well, although also many years ago. Unlike you I didn't actually choose one. As best I recall the ones I looked at created two separate accounts for you. One holds your original capital (call that pot A) and the other gets all the income, profits and gains from that capital (pot B).

The one difference from investment bonds that I recall is that there is no restriction about 5%. You can withdraw any amount or nothing at any time, as you wish. The point being that if, say, your original capital was 100K then the first 100K's worth of withdrawals were deemed to be from your original pot, and so obviously no tax would be due on that payout - it was a simple return of your capital.

It was only when you had taken that 100K that you started withdrawals from pot B. As you note, income tax is due on every penny of pot B, but you might later be retired or no longer subject to UK tax, in which case that may not matter.

So it was a nice idea. What I don't know is if HMRC has subsequently taken a look at these schemes and ruled that they don't pass muster somehow. Although they are probably mostly popular with non residents, who might decide that they don't care what HMRC thinks

[WorkShy]

I have an offshore life bond, which is Lux based. The mains advantages: gross roll-up of returns, the 5% withdrawal of the original principal per year without triggering a tax charge, top-slicing relief and the ability to reassign units between family members. The main disadvantage is that all gains are taxed as income, not CGT. This issue is mitigated, however, by top-slicing relief which used intelligently should result in you or your family never paying more than 20%. Realistically, you can also avoid IHT, at least until the last named member dies (so typically you name all your children as beneficiaries).

The fees are quite high since they operate on a bp of NAV basis. I pay 40bp running plus 5bp for custody but I've heard fees can often be over 100bp for those that only subscribe small amount of say a few hundred thousand or so. I don't think these products really work unless you intend to have at least a seven figure sum invested in them. Scale will help drive the fees down.

Overall, I think they are a useful part of the armoury of products that exist. Once you've filled up ISAs and pensions then some form of offshore trust or life bond is a good diversifier, especially if you think you might become an expat.

[BusyBumbleBee]

Trying to find ways to save tax can lead you to VCTs (and EIS schemes). VCTs were once a very useful means of saving tax. You not only got 20% of your investment back by way of an income tax refund (now 30%) but also you were able to defer CGT of 40% (that has now gone) so you could effectively buy a £1 share for 40 pence and from then on all dividends were tax free (and originally you got the advance corporation tax back as well!).

However, changed rules mean these investments are much more risky than they were before and I would recommend extreme caution. You can also buy these in the second hand market if you really brave - up to £200K's worth per year and the dividends will be tax free forever. In the past this has proved very profitable for me - but there are precious few bargains about at the moment, So unless you are really keen and do a lot of research don't let the tax tail wag the dog.

If this doesn't put you off then look at the VCT board here on the Lemon Fool - there are some real experts there.

[OhNoNotimAgain]

I worked for many years for a US IT company that has spent a fortune over more than 20 years buying its own shares, at the same time as cutting costs to an extent that crippled any ability to deliver quality services. During this period the share price performance has been woeful, the revenue has progressively declined, profitability has reduced, but the senior execs all trousered great performance bonuses because EPS targets have usually been met. At some point the death spiral will destroy all remaining share-holder value, but a small number of execs will have become very rich indeed. It could be that for some companies share buy-backs make sense, for my previous employer, a business that generates a huge amount of cash, if share-holder value was indeed the motivation (as always stated, cynically some might think), then surely a capable management team could think of more useful things to do with the cash?

Andrew

Spot-on. A lot of share buy-backs exist just to minimise the dilution caused by the issuance of share options to executives as a bonus for hitting a target that they designed themselves, such as adjusted eps that are increased by, amongst other things, share buy-backs.

[Fluke]

Whilst I have nothing to add to this thread, I will just refer to what I consider to be the bible on share buybacks. IMHO Everyone that invests in shares of companies (especially those regularly doing buybacks) should read this PDF by Terry Smith and team...

https://www.fundsmith.co.uk/docs/defaul ... ?sfvrsn=18

All the best, Si

For those who don't want to read the whole thing (which is well worth reading, by the way!)

Summary

Most share buybacks now destroy value for remaining shareholders

Thanks for the link Simoan I second vrdiver, the report is well worth reading, here are 3 more points from the summary:

• Share buybacks are not sufficiently understood by company investors and commentators, and maybe by company managements (although some of them may understand them perfectly well but not be using them to create value for anyone other than themselves)

• Share buybacks only create value if the shares repurchased are trading below intrinsic value and there is no better use for the cash which would generate a higher return

• Current accounting for share buybacks conceals their true effect

Maybe not such a beautiful thing after all.

[Fluke]

I worked for many years for a US IT company that has spent a fortune over more than 20 years buying its own shares, at the same time as cutting costs to an extent that crippled any ability to deliver quality services. During this period the share price performance has been woeful, the revenue has progressively declined, profitability has reduced, but the senior execs all trousered great performance bonuses because EPS targets have usually been met. At some point the death spiral will destroy all remaining share-holder value, but a small number of execs will have become very rich indeed. It could be that for some companies share buy-backs make sense, for my previous employer, a business that generates a huge amount of cash, if share-holder value was indeed the motivation (as always stated, cynically some might think), then surely a capable management team could think of more useful things to do with the cash?

Andrew

Spot-on. A lot of share buy-backs exist just to minimise the dilution caused by the issuance of share options to executives as a bonus for hitting a target that they designed themselves, such as adjusted eps that are increased by, amongst other things, share buy-backs.

This is nicely illustrated on page 10 of the report linked to by Simoan:

When Fred took over as CEO of Stagnant Inc he realised that he had no hope of generating any growth so he just did two things: a) he got himself a 10 year option over 1% of the company’s issued share capital at the current share price, and b) stopped paying a dividend.

Instead he used all of the net profits to repurchase stock.

You need to see the table (figure 11) of how the rising EPS after each share repurchase in turn links to Fred's share options in year 10.

And to circle back to the OP, this might be why HYPer's should not be too thrilled with share buy-backs.

[Gengulphus]

There has been a useful exchange of views in this topic. Companies always describe share buybacks as returning money or value to the shareholders. ...

Which is what they are doing. They're not creating value for shareholders, except in the sense that people generally value wealth they own and fully control somewhat more highly than wealth they own but only control in a limited way. Statements that buybacks "enhance shareholder value" or such like are at best rather misleading, but buybacks do return already-created value to shareholders.

And no method of returning value to shareholders creates value for them, including ordinary dividends - they're all methods for transferring already-created value to shareholders, not for creating it in the first place.

... One desired objective is to enhance the share price. ...

Depends whose "desired objective" you're talking about! Basically, if a company's total fair value is V and it has N shares in issue, then its fair price is P = V/N. If it then buys back M shares at a price of Q, its fair value becomes V-M*Q because of the cash that leaves the company and the fair price of a share becomes R=(V-M*Q)/(N-M). So (N-M)*R = V-M*Q = P*N-M*Q, which rearranges to give P*N = M*Q + (N-M)*R. Dividing through by N gives P = (M/N)*Q + ((N-M)/N)*R), which basically says that the old fair value P is a weighted average of the price Q paid for the buybacks and the new fair price R, with weights M/N and (N-M)/N (which add up to 1, and both lie in the range 0 to 1 for possible values of N and M). A weighted average of two values lies between the two values, and so R will be above P if Q is below it, and vice versa. I.e. as various people have said in the thread, buybacks below fair value are a good thing for the remaining shareholders, and buybacks above fair value are a bad thing for them. For shareholders who sell into the buyback, it's exactly the opposite way around.

As for all market trading decisions, there is of course the crucial issue of just what the "fair value" of the company is. The directors make the buyback decisions (including the maximum price the company will pay), either themselves or by delegating them to underlings or advisors, and their decisions may be affected in various ways by biases and/or conflicts of interest. That is IMHO the fundamental issue that lies behind most of the potential (and not infrequently actual) problems with buybacks, such as (not by any means a complete list):

* Bias because it's very hard for directors to take a truly objective view of their company. Basically, a major part of their job is to form plans for the future of the company's business and put them into operation - and they generally have to believe those plans have a good chance of success (there is the alternative that they don't think it's a good chance, but it's the best chance there is - but that means that the company is probably in trouble and ought not to be returning cash until that trouble is resolved!). They ought to (and probably will) also have some contingency plans for them going wrong, but their minds are generally focussed on the main plan's success. And that makes them very naturally disposed to seeing the company's future through rose-tinted glasses - it's possible to tone down the amount of rose-tinting, but it takes effort and willpower, and it's rarely (if ever) completely successful.

* Conflicts of interest between assessing fair value properly and keeping their jobs, caused by major shareholders who want to unload their shares at above fair value, and who can vote the directors out of office if they don't do the buybacks, or to make it considerably more likely to happen by trying to persuade other major shareholders. Note that the threat to actually do so is implicit in that situation and doesn't need to be made explicitly - and generally isn't, at least in public.

* Conflicts of interest between assessing fair value properly and keeping their word (and hence reputation). The clearest examples of that are IMHO when a company announces that it will return a specific large amount of cash (e.g. £2b) to shareholders by buying back shares. That basically says to the market "We'll pay whatever price you demand", and it's hardly surprising that in consequence, shareholders who want to sell but aren't in any particular hurry to do so decide to hold out for prices they believe are clearly above fair value! There probably won't be enough sellers around who want to sell fairly urgently to satisfy the company's demand for buybacks, and so the price settles somewhere above the market's view of fair value. That view of what fair value is may well be wrong, of course, but it can easily be wrong in either direction, and so the company ends up doing the buybacks at above fair value. How far above fair value is basically a matter of the collective greediness of the shareholders who want to sell at above fair value: the price will rise until a sufficient number of them are persuaded to satisfy the company's demand.

* Conflicts of interest between the short-term performance targets and rewards of share incentive schemes and the long-term objectives of the company. The often-used argument that taking shares out of issue with buybacks raises EPS, so that there is clearly such a conflict for share incentive schemes that use EPS as a performance target, is rather incomplete: incentive schemes are intended to reward directors for benefits to shareholders, so it is hardly a criticism of them that the shareholder benefit of an increase in EPS results in an increase to the incentive! But if the incentive scheme's performance targets and rewards are assessed and rewarded on a short-term basis, that produces a conflict of interest between using cash to drive the share price up short-term and using it to enhance the long-term value of the company. I've never yet seen an incentive scheme that IMHO avoided that conflict (and to put that in context, I regard timescales of anything less than ten years as "short term" for this purpose).

* When the directors delegate the job to underlings or advisors rather than making the decisions themselves, the underlings or advisors are likely to have a conflict of interest between not overpaying for shares and pleasing the directors by getting the buyback completed, which will lead them to push for a maximum price to pay that is above fair value.

* Very obvious conflicts of interest if the directors themselves sell into the buybacks!

... We have only to look at the example of Lloyds Bank Group to see that this approach has been a failure. If the money had instead been used to enhance the dividend, the share price would have risen to reduce the yield to a sensible level. That would truly be giving more value to the shareholders.

It's only a failure if the objective of the buybacks is to increase the share price - but as I indicate above, I don't think it should be, and if it was, it's hardly surprising that it's failed at that objective. It should primarily be to buy back shares for no more than fair value, with fair value determined in a way that is not affected by the very hard-to-completely-avoid director biases and conflicts of interest. The share price should increase if the shares are bought back for less than fair value, but that should not be the primary objective, and because the biases and conflicts of interest are so hard to avoid, I'm never surprised when the price ends up falling as the longer-term outcome of buybacks... Though in this case, I suspect that the current strong influence of politics on market sentiment about banks and other financials is probably a much more major factor!

If the company wishes to reduce the number of its shares, then surely a return of capital to the shareholders, coupled with a share consolidation, is a far more satisfactory and equitable method. If a company wishes to raise more capital, the shareholders have the right to be the first to contribute via a rights issue, unless that right is waived by a resolution passed at the AGM. Surely the converse should be mandatory.

I agree about the inequitability of (most) buybacks - though I would make an exception for buying shares back by a tender offer (a very rarely-used method, regrettably IMHO), since that does give shareholders a fair opportunity to choose whether to take part or not.

But the converse is mandatory! Companies have to get buybacks approved by shareholder resolution in order to be able to do them legitimately, and just as with rights issues, resolutions to approve them (within limits) are routinely put to AGMs and passed.

Gengulphus

[vrdiver]

All too often we see on these boards grumpy Fools whinging that a share buyback is taking place. The petulant mutterings usually go something like this: “Buybacks are reducing my dividend.... They used to be illegal...management want their share options to trigger”

OK. Ignoring the pejorative tone for a moment, let's get down to facts.

As you've raised the issue, please provide a list of such complaints with the associated details of the share buy back (price, date) and current price.

VRD

Bump.....

Seems to have slipped your mind.

VRD

[GoSeigen]

If the company wishes to reduce the number of its shares, then surely a return of capital to the shareholders, coupled with a share consolidation, is a far more satisfactory and equitable method.

??

Maybe a company like Lloyds doesn't want to return capital to its preference shareholders or cannot. What does it do then?


GS

[tjh290633]

If the company wishes to reduce the number of its shares, then surely a return of capital to the shareholders, coupled with a share consolidation, is a far more satisfactory and equitable method.

??

Maybe a company like Lloyds doesn't want to return capital to its preference shareholders or cannot. What does it do then?


GS

Who mentioned preference shareholders?

In any case, a tender buy-back, where shareholders can participate or not, at their choice, is the best method by far.

TJH

[Bouleversee]

I worked for many years for a US IT company that has spent a fortune over more than 20 years buying its own shares, at the same time as cutting costs to an extent that crippled any ability to deliver quality services. During this period the share price performance has been woeful, the revenue has progressively declined, profitability has reduced, but the senior execs all trousered great performance bonuses because EPS targets have usually been met. At some point the death spiral will destroy all remaining share-holder value, but a small number of execs will have become very rich indeed. It could be that for some companies share buy-backs make sense, for my previous employer, a business that generates a huge amount of cash, if share-holder value was indeed the motivation (as always stated, cynically some might think), then surely a capable management team could think of more useful things to do with the cash?

Andrew

Spot-on. A lot of share buy-backs exist just to minimise the dilution caused by the issuance of share options to executives as a bonus for hitting a target that they designed themselves, such as adjusted eps that are increased by, amongst other things, share buy-backs.

This is nicely illustrated on page 10 of the report linked to by Simoan:

When Fred took over as CEO of Stagnant Inc he realised that he had no hope of generating any growth so he just did two things: a) he got himself a 10 year option over 1% of the company’s issued share capital at the current share price, and b) stopped paying a dividend.

Instead he used all of the net profits to repurchase stock.

You need to see the table (figure 11) of how the rising EPS after each share repurchase in turn links to Fred's share options in year 10.

And to circle back to the OP, this might be why HYPer's should not be too thrilled with share buy-backs.

Didn't Berkeley do the same thing? I can't think of a single case where buybacks (buying in the market) have returned me anything, other than back to a lower share price in some cases. I am convinced they are largely for the benefit of the directors.

[Alaric]

Didn't Berkeley do the same thing? I can't think of a single case where buybacks (buying in the market) have returned me anything, other than back to a lower share price in some cases. I am convinced they are largely for the benefit of the directors.

If the buybacks results in a higher market price, funds and their holders would benefit from the higher price, thus improving performance. It's a rather more nebulous advantage for a buy and hold investor, since they would have to sell to see any benefit. Other methods such as special or enhanced dividends and returns by way of capital reorganisation would see cash in the bank account of the holder at the possible or probable expense of the market price.

[GoSeigen]

If the company wishes to reduce the number of its shares, then surely a return of capital to the shareholders, coupled with a share consolidation, is a far more satisfactory and equitable method.

??

Maybe a company like Lloyds doesn't want to return capital to its preference shareholders or cannot. What does it do then?


GS

Who mentioned preference shareholders?

I did. Preference shareholders have the right to prior payment in a return of capital. If the ordinary shareholders cannot or do not want to give the pref holders their money first then they have no right to the capital of the company. They can only receive distributions (after paying preference holders their dividend). Can you say that this is not an issue for LBG?

GS

[tjh290633]

If that is a problem, then the answer is a tender offer to buy shares from the shareholders.

TJH

[Alaric]

If that is a problem, then the answer is a tender offer to buy shares from the shareholders.

Preference shares are usually first in the queue when it comes to payment of dividends. Hence the name. Terms vary by issuer, but something that says the preference shares are also ahead of ordinary shareholders if there's a return of capital is also common. The Aviva issues had clauses to such effect. It's to stop the Ordinary shareholders instructing the Directors to pay out most or all of the Company's value to themselves, leaving the Preference shareholders with next to nothing.

Tender offers including a buyout of the Preference shareholders could well be possible.

[TheMotorcycleBoy]

All too often we see on these boards grumpy Fools whinging that a share buyback is taking place. The petulant mutterings usually go something like this: “Buybacks are reducing my dividend.... They used to be illegal...management want their share options to trigger”

They are, of course, entitled to their opinion.

No matter how wrong they are.

Shareholder returns are a combination of dividends and share price appreciation.

Now it is true that diverting cash from a dividend to a buyback is going to reduce income initially. However a share buyback is as good or as bad as the price it is executed at. If the company buys shares below the true value of the company then they are fantastic. Fewer shares in issue is a good thing for improving earnings per share in future.

If the company buys shares at an inflated value then they are a waste. Overpaying for something usually is.

The thing is, management are often in a great position to value the company. Management get lauded and rewarded for improved EPS. They have the industry knowledge and understand far better than most where the company sits against competitors. No manager truly wants to waste money on doing anything that will impair EPS. So a buyback might be taken as one indicator that the company may be undervalued.

And an extra buyer in the market is a positive for shareholders generally, adding liquidity. Buybacks are often more favourable than dividends in terms of tax treatment, as their benefit (if one exists) accrues only on disposal and thus is treated as capital gain at a time of your choosing rather than taxed as income.

We must also consider cost of capital: if a company is paying a 10% dividend on shareholder equity, but can borrow at 5%, it might make sense to take on extra debt to buyback shares, as the overall cost of capital is lowered. In the converse situation the wiser action might be to pay down debt.

The side effect of this is to change the debt ratios of the company, an altered debt/equity split and that will affect the market perception of the bankruptcy default risk of the firm. In general, a lower cost of capital is good news. In this way the company is able to optimise its debt/equity split to reduce its cost of capital, lower its bankruptcy risk and improve overall returns.

So are buybacks a good thing? The answer: it depends.
But HYPers carping about share buybacks ought to consider that in an era of ultra-low-cost bank finance, their expensive dividends can look unwise on a cost of capital basis. They should expect more buybacks in future. Why yield extra shareholders 10% when you might raise debt to buy em out cheaper, and make the company more profitable by doing so.

So, in short, readers should know that the anti-buyback crowd on LemonFool are misguided and exhibit a certain myopia about dividend income. They seem blind to the risk to their investments posed by suboptimal corporate structures with high cost of capital. Getting the optimum corporate structure to lower cost of capital is unequivocally a good thing, and if buybacks are used as a means to do so then they are to be welcomed.

Prof Damodaran on buybacks in this classic article: https://aswathdamodaran.blogspot.com/20 ... e.html?m=1

Cost of capital: https://en.m.wikipedia.org/wiki/Cost_of_capital

Ok,

What do you propose that businesses will do once they have bought back all the stock that they are legally entitled to do?

Matt