5 minute read
The Case for Share Repurchases
Share repurchases have been a hotly debated topic, particularly in the developed world, for a number of years now, and yet it somehow still remains one of the most misunderstood and maligned corporate actions.
The reason why the subject is topical in Namibia right now is the fact that two of the locally listed companies on the Namibian Stock Exchange, i.e. FirstRand Namibia and Capricorn Group, have in recent months announced plans to potentially buy back their shares. Buybacks have up until now not been a common occurrence in Namibia, making this the ideal opportunity to inform investors what they are and why they are potentially preferable over other capital allocation decisions.
A share repurchase/buyback is simply the practice whereby a firm’s management uses cash, or takes on additional debt, to buy back a portion of the shares of its own corporation that were previously sold to the public. Seeing that companies raise equity capital through the sale of shares to the public, it may seem counter-intuitive that a business might choose to give that money back, but there are several reasons why it may be beneficial for a company to do so.
One of the common critiques against buybacks is that they are somehow bad for the economy. The argument is that each dollar spent on buying back shares is a dollar that is not spent on expanding business operations that could stimulate economic growth. However, what gets ignored in this argument is the fact that the capital that gets disseminated from the repurchase will likely be reinvested somewhere else. Shareholders have access to a wider set of investment opportunities than the management teams of companies. Directing the buyback proceeds to these opportunities not only allows shareholders to diversify their investment portfolios, but also aids economic growth by directing capital towards companies and projects which could potentially offer returns higher than the cost of capital.
A repurchase is a form of capital allocation. By using capital to buy back shares in the existing business, the management team is investing in an entity that they know and understand better than any other external investment opportunity. Large capital projects by contrast, have a greater risk of running over budget and often fail to achieve their cost of capital, leading to value destruction. When a company is sitting on excess cash, it is better to return it to shareholders than to specifically go in search of a project just because it has the funds lying around, because that could easily lead to value destruction.
Furthermore, repurchases are permanent investments. Shares that are bought back no longer form part of a firm’s issued shares, which means it is a dividend that is saved because it is a share that is no longer in public hands and the value per share is improved permanently.
Another common argument against buybacks is that they ‘shrink the business’. This is not the case since the firm’s operations are ongoing and its operating assets do not change. For long-term investors who opt to not sell their shares back to the company, buybacks are advantageous because it increases their proportional stake in the firm, since fewer shares are available to the public.
Liquidity on the Namibian Stock Exchange is considerably lower than on larger exchanges such as the JSE, where institutional investors, such as pension funds, generally buy shares and hold them for significantly longer periods of time than retail investors, who are more likely to sell their shares, particularly when economic conditions are challenging. This means that price discovery is poor and often leads to the shares of the Namibian companies trading below their fair/intrinsic values. In this case, a share repurchase is advantageous to long-term investors, because a natural buyer in the market supports the share price. It is advantageous to investors who want to liquidate their holdings, and lastly it enhances the financial ratios of the firm.
The Namibian commercial banks are overcapitalised, and with credit demand remaining low and the outlook for economic growth lacklustre, in our view it makes sense for them to explore this form of corporate action. It should be noted that although the shareholders of FirstRand Namibia and Capricorn Group have voted in favour of the company buying back its shares, it is not a guarantee that they will do so, but it gives them the freedom to do so.
The biggest drawbacks of share repurchases are that the management team could overpay for the shares and that buybacks reduce the available cash on the company’s balance sheet. However, given the alternatives that the cash is either spent on low yielding, value-destroying projects, or lies dormant in the firm’s bank account, we still prefer the buyback option, as it creates more value.
Based on the arguments made here, we are very much in favour of share buybacks as a form of capital allocation, particularly when few growth opportunities exist for businesses, and we believe that buybacks should be pursued by more listed companies.
Danie van Wyk – Head: Research
