Artemis: Should investors welcome share buybacks?

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Management teams across the UK are so fed up with the lack of demand for their companies’ shares that they are using profits to buy them themselves. ‘Share buybacks’, as they are called, have rarely – if ever – happened at such a rate. And it is not just the FTSE 100 giants snapping up their own bargain shares. Small companies are now getting in on the act.

Thirty companies on the FTSE All-Share index saw their number of shares fall by 5% or more in 2023 – largely as a result of share buybacks¹. Over three years, 27 companies have bought back 10% or more of their shares. Last year, around one in eight listed UK smaller companies bought back shares².

Within our own small-cap fund, 11 companies bought back their own shares in 2023. I have been managing money in small caps for 30 years and have never seen anything like this.

So why is it happening? What does it tell us about the UK market? And is it good or bad for investors?

Understanding buybacks

A company has a number of choices about what it does with its profits. It can reinvest for future growth, which includes mergers and acquisitions; it can distribute the cash to investors in the form of dividends; or it can buy back its shares.

In theory, an investor should be no worse off whether the company issues dividends or buys back shares. If the number of shares in circulation decreases and the value of the company remains the same – as it should – the share price should rise.

Some shareholders say it is better to have the money as a dividend. I disagree. Investors should think in terms of total return – income and capital growth.

If you do want the extra income, you have the option to sell some of the shares. This can work out as more tax-efficient for many investors as income is typically taxed at a higher rate than capital gains (but check with an expert before making any decisions).

Mixed views

Buybacks are often criticised as being a sleight-of-hand way of rewarding management, who are often rewarded on the basis of the earnings per share (EPS – the calculation of the profits of a company that are attributable to each share in that company. EPS is calculated by dividing the profits of a company after tax by the number of shares in issue). If a company buys back shares, those earnings per share automatically rise. If they pay a dividend, they do not. This can inflate management pay and bonuses.

In addition, some companies (wrongly, in our view) pay management in part with new shares and then exclude the cost of this from their underlying EPS figures, which can artificially flatter earnings and negate the benefit of buying back shares. So we have to be alert.

The other problem with share buybacks is that companies that make a virtue of buying back shares may do so when the price is high. Buying back shares at an elevated price benefits selling shareholders but is to the detriment of long-term holders.

We are perfectly comfortable seeing UK companies buying back their shares when they are as cheap as they are today. Our focus is on identifying companies with a high return on capital, generating strong cash flows. These traits give companies multiple different options.

If buybacks receive mixed views, what does the data suggest? Research shows that since 2016, the top 20% of FTSE SmallCap companies by buyback yield – in other words those spending the most on buybacks as a proportion of their market capitalisation – have delivered around twice the total return of the whole index³.

Market view

So what does this all tell us about the UK today? Everyone knows that the UK is cheap relative to the rest of the world. A common measure of value is the ratio of a company’s share price to its earnings. This multiple is almost as low as it was in 2008/9 and similar to its level in the Covid anxiety in 2020. Smaller companies are especially cheap – even though smaller companies have historically outperformed their larger counterparts by a massive margin.

Data from Numis shows that if someone invested £1,000 for a new-born baby in UK small caps in 1955 and reinvested dividends, by the time the baby had grown up and retired in 2022 – aged 67 – this amount would have grown to £9m. The same amount invested in UK larger companies over the same period would also have multiplied your wealth – but to just £1m. Smaller companies can deliver strong returns in fits and starts, but over the long term they can make a powerful difference to your portfolio.

The assumption in the rest of the world is that the UK is struggling and that smaller companies face an especially tough time. This is just not what we are seeing in meetings with most of the companies we own or are interested in.

No one knows these companies as well as the people running them, and if they think their shares are cheap, then buying them back is a vote of confidence in the business.

This buyback activity should be a reminder that not all smaller companies are heavily indebted. Lots are generating excess cash. We see this as another buy signal for small caps and the UK market as a whole.

If the UK market recovers, it could bounce back sharply, like a coiled spring unwinding. We believe buybacks are a signal of the value building in UK stocks and should be embraced.

¹The FTSE All-Share includes the biggest 350 companies in the UK and the FTSE SmallCap Index. This list does not include investment trusts, some of which have in place discount control policies that force them to buy back their shares when discounts widen. Source: Bloomberg
²Bloomberg
³Liberum, Datastream