Buybacks and their importance

One of the critical tools used by corporations globally and especially in the US to return capital to investors is buybacks of stock. Partly done to offset dilution due to share-based employee compensation and partly due to greater tax efficiency, it has become the primary means to return capital to investors. One of the less well-known facts is that since the year 2000, net share buybacks in the US have totalled $5.5 trillion. They have been the single-largest source of demand for US equities. The next biggest source of demand has been buying from foreign investors, and that totalled $1.8 trillion in this period. Since the year 2000, buying from domestic retail investors has totalled only $100 billion (households and mutual funds). One of the biggest reasons for US exceptionalism in terms of stock market performance has been this dynamic of large, sustained net buying by US companies of their own stocks. The scale and pace are unprecedented compared to any other geography. At the moment we are seeing gross buying of about $1 trillion per annum in terms of actual buyback execution from US companies and this number continues to rise. Beyond the obvious imperative to neutralise share-based compensation, share buybacks have now become accepted wisdom as the primary means to return capital to shareholders. All the technology giants have come on board, with each of them having large buyback programmes. Even the poster child of growth stocks, Nvidia, as recently as six months ago, announced a $25 billion buyback.
 

If we look at a more micro level, Apple is a very good example of the power of buybacks. Till recently the world’s most valuable company, buybacks have been a critical part of its shareholder value equation. iPhone sales began to slow in 2015. Since then Apple has grown its earnings per share (EPS) at a compound annual growth rate of approximately 13 per cent (2015-23). Interestingly in this period top line growth was only 6.4 per cent per annum, and pre-tax profits grew only 5.7 per cent. The gap was made up by lower tax rates and share buybacks, which combined to deliver over 6.7 per cent per annum EPS growth. Of the 13 per cent EPS growth, fully 5 per cent was delivered by net share buybacks. Share buybacks have been over $550 billion during this period and the company has retired over 30 per cent of its share count. Share buybacks were most critical between 2015 and 2019, when pre-tax profits actually declined and the company bought back nearly 6 per cent of its shares every year with the peak being 7 per cent retired in 2019. Even today the company buys back more than $85 billion of stock every year.
 

Apple is an exceptional company with a free cash flow (FCF) conversion of 112 per cent and given that it has limited capital spend and acquisitions, it has been able to pay out an average of 101 per cent of its FCF to shareholders over this period. Its profits and FCF at over $100 billion are also on a different scale. Apple does pay dividends, but chooses to pay only about 15 per cent of its FCF through this route of capital return, and 85 per cent of FCF is returned via buybacks. Is it not surprising that for the world’s most valuable company, fully 40 per cent of its earnings growth between 2015 and 2023 has come from share buybacks.
 

Since Apple started down this path of capital return, it has had a noticeable improvement in valuation. Its relative price/forward earnings were 0.6 in the beginning of 2016. This is now 1.25, having peaked at 1.5 times. Part of the valuation expansion is undoubtedly due to the market treating the company as a consumer franchise rather than a hardware company, but part of the credit must also be given to the decision to return all the FCF to shareholders. Higher payout ratios are clearly linked to higher valuations and rising return on equity. Investors do not like companies squatting on excess cash.
 

This is the power of buybacks and capital return. What is the relevance of all this for India? In our markets beyond the information-technology services giants and a few exceptions like Bajaj Auto, nobody uses buybacks. Partly there is limited tax incentive to do so and not much share-based compensation, and even today most Indian companies consider capital returns as a signal of having gone ex growth. Many promoters still consider the cash in the company as their money and are averse to sharing this pie with minority investors.
 

There is also the risk that given the current optimism around the long-term prospects of the country, there is desire to keep investing even if the core business does not require all the profits being generated. In today’s India every growth opportunity looks exciting. Markets have also lost a bit of their focus on capital discipline and may not penalise companies going into unrelated growth areas.
 

This is a time of high profits and cash flows. Animal spirits of corporate India are rising. Everyone is optimistic and bullish. The worst mistakes are made in the best of times. Capital discipline can easily slip. Hopefully companies will closely evaluate any unrelated business investment and realise that capital return is a viable option. Paying money back to shareholders does not mean that you have no growth. It may simply mean that you do not need all the capital you generate for your core business. Times like today of strong corporate profitability are the most dangerous for investors. This is where the art of capital allocation comes into view. Companies must maintain their standards for return on capital thresholds. That is how they got their premium valuations and rising payouts will not lead to valuation compression.
 

This is an especially important lesson for our next-gen companies, many of which will hit the markets soon. Once they achieve profitability, many of these companies have limited capital intensity and will generate large FCF. Instead of continually entering new businesses and using the cash, there may be a case for them to consider capital return and buybacks. They will anyway need to offset share dilutions, but can do many more share buybacks than required to simply offset share-based compensation.

Every company has its own unique set of circumstances and growth options. Capital return must be one of the options management considers when thinking of capital allocation. All new growth projects and businesses do not always make sense. Despite the current temptation, we must stick to thresholds based on return on capital. As investors we also have an obligation to enforce capital discipline through markets and valuations.

The writer is with Amansa Capital