Michael Mauboussin of Legg Mason Capital Management recently published a great finance piece on share buybacks. Officers and directors of successful corporations must decide what to do with excess cash. This is an issue for many officers and directors today, as nonfinancial companies are sitting on $1.7 trillion in liquid assets.
What are share buybacks?
A share buyback is the repurchase of outstanding stock from shareholders. Buybacks are an alternative to capital expenditures, acquisitions, and dividends.
When should directors and officers authorize share buybacks?
A company should repurchase shares when its stock is trading below its expected value and when no better investment opportunities are available.
When a company buys back stock, regardless of whether the stock is overvalued or undervalued, value is conserved. The difference between buying back overvalued stock as opposed to buying back undervalued stock is which group of shareholders receives more value. When overvalued stock is repurchased, the selling stockholders receive a windfall at the expense of the non-selling shareholders. In contrast, it is the non-selling shareholders that are most benefited from a repurchase of undervalued stock. Assuming that management’s objective is to maximize the long-term value for ongoing shareholders, repurchases are ideal when stock is undervalued.
How is it that buybacks can be more appealing than dividends?
There are a few ways that buybacks can be more appealing than dividends:
- There is a common perception that once dividends have been issued, management tends to increase or match the dividends annually. Thus dividend offerings are sometimes seen as more of a long term commitment than share buybacks which aren’t seen as recurring events. Because there is no expectation that the buybacks will be recurring, they offer management greater flexibility.
- Dividends are taxed. Shareholders that do not sell shares in a buyback receive a benefit equivalent to a dividend in having a more concentrated holding of the company, but they get to defer their taxes.
- If investors want cash, like they would receive in a dividend, they can get a “synthetic dividend” by participating in the buyback. If they sell a pro-rata share of their holdings, they will receive cash, and maintain their percentage of holdings.
- Many shareholders don’t need the dividends, and will just reinvest the dividends after receiving them. There is a transaction cost associated with reinvesting. The dividend is taxed and then the shareholder will have to pay to reinvest either in the same company or in a different one.
If executives and directors think they can get a better return on the capital by reinvesting it in the business, then by all means, they should do so. However, growth for the sake of growth can be detrimental to corporations. Businesses can become too large to be efficiently managed. Directors and officers should be careful to not let the objective of growth come into conflict with the objective of maximizing long term shareholder value. If reinvesting in capital in the business is not an efficient way to build value, buybacks can be an appealing alternative use of excess cash.
Rule 10b-18: A Safe Harbor for Stock Repurchases
If corporations comply with the requirements of Rule 10b-18, they can be free from liability for manipulation under sections 9(a)(2) of the Exchange Act and Rule 10b-5.
To come within the safe harbor an issuer’s repurchases must satisfy (on a daily basis) each of the section’s four conditions. Failure to meet any one of the four conditions will remove all of the issuer’s repurchases from the safe harbor for that day. The safe harbor, moreover, is not available for repurchases that, although made in technical compliance with the section, are part of a plan or scheme to evade the federal securities laws.
The primary requirements of the four conditions are:
- Rule 10b-18 purchases must be effected from or through only one broker or dealer on any single day;
- Rule 10b-18 purchases must not be: the opening purchase; effected within the last half hour of the primary session of the principal market (there are other timing restrictions);
- Rule 10b-18 purchases must be effected at a purchase price that: does not exceed the highest independent bid or the last independent transaction price, whichever is higher, quoted or reported in the consolidated system at the time the Rule 10b-18 purchase is effected; and
- The total volume of Rule 10b-18 purchases effected by or for the issuer and any affiliated purchasers effected on any single day must not exceed 25 percent of the ADTV for that security.
If you have any questions about share buybacks, please feel free to post a comment below or contact inVigor Law Group.