LONDON -- Share buyback programs tend to have a poor reputation among private investors. If a company has surplus cash to disperse, many prefer to see it paid out in a dividend. So news that Warren Buffett's Berkshire Hathaway group is buying back shares in spades sends confusing messages. The Oracle of Omaha's words of wisdom are followed by private and professional investors alike, and in the past he's been less than complimentary about buybacks.
However, last week Berkshire Hathaway boosted its 1-year-old buy-back program with a $1.2 billion purchase from a single long-term investor and doubled the premium over book value at which repurchases can be made from 10% to 20%. That's expected to foreshadow more repurchases, though it's unlikely to dent Berkshire Hathaway's $48 billion cash pile.
There is no shortage of companies on the FTSE 100 buying their own shares at the moment. Companies such as British American Tobacco , Imperial Tobacco , GlaxoSmithKline , and Wm. Morrison announce purchases practically daily.
So just what are the pros and cons of share buybacks, and why is it such a common strategy these days?
The traditional argument is that share buy-backs are a tax-efficient means of returning surplus capital to shareholders. It should boost the share price and so produce a capital gain, rather than income, which is often taxed at a higher rate. By reducing the number of shares in issue, it also increases earnings per share, which supports dividend growth in the long run.
Critics say it represents an unadventurous use of cash and is frequently motivated by management's desire to increase the share price and/or EPS on which bonuses and long-term incentive programs are based. But perhaps the most damning indictment is that companies frequently time it badly, buying shares at a high, only to see the price decline later.
I see four reasons why buybacks are so prevalent these days:
Companies have surplus cash but, with low confidence, are nervous about investing in new projects or acquisitions.
Valuations are historically low, so companies are less fearful of buying their own shares at the wrong price.
Dividend yields are high, and companies are reluctant to commit to possibly unsustainable dividend increases.
Interest rates are low, so the interest lost on cash surpluses or the cost of increased debt to fund buybacks is relatively low.
It's no surprise to see the tobacco companies, BATS and Imperial, among those with big buyback programs. They are prodigious cash-generators but in a mature and highly consolidated industry -- arguably ex-growth -- so they have few opportunities for acquisitions and limited capital-expenditure, but they would probably not want to push their dividend yields past 5%.
It's more surprising to see Wm. Morrison on the list. Supermarkets are still investing heavily to fight intense competition, and Morrison is playing catch-up with the sector in online sales and convenience stores. But in March 2011 the company committed itself to a two-year program to buy back 1 billion pounds of shares. With Morrison's gearing below the sector average, the plan is designed to boost shareholders' returns.
Like the tobacco companies, GSK generates vast amounts of cash, but it would have more opportunities to spend it through acquisitions. Generally the pharmaceutical sector is investing, especially in biotech, to secure its long-term future as blockbuster drugs go off patent. But in 2011, GSK returned all its free cash flow to shareholders through 3.4 billion pounds of dividends and 2.2 billion pounds of share purchases, and it's targeting more buybacks this year.
Rival AstraZeneca changed tack in October when new CEO Pascal Soriot took over. He immediately put a stop to its 4.2 billion pound buyback program, of which roughly half had already been spent. That looks like a good sign that the company will invest, by acquisitions or through research and development, to address its impending patent cliff.
But the market has yet to see what Soriot will do. It may be unimaginative to return cash, but investors like share buybacks if they stop management from making silly acquisitions.
That thinking may be one of the factors behind Buffett's share repurchases. He sees no attractive opportunities to spend Berkshire Hathaway's massive cash pile and is unwilling to make acquisitions for the sake of it.
One investment he did think worthwhile is right here in Britain. The Oracle of Omaha has invested in just one British company with large purchases over several years, including this year. To learn its name, you can download this free Motley Fool report: "The One U.K. Share Warren Buffett Loves." Just click here.
The article Buybacks: Now Even Buffett's Doing It! originally appeared on Fool.com.
Tony owns shares in BATS, Imperial, and GSK but no other shares mentioned in this article. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.