Yesterday was all about buybacks, with news of a $500 million on-market buyback by Qantas Airways Limited (ASX: QAN), a $270 million off-market buyback by Caltex Australia Limited (ASX: CTX), and an $80 million plus buyback by Seven Group Holdings Ltd (ASX: SVW).
There was also a surprise dividend announcement by BHP Billiton Limited (ASX: BHP), which feeds into the larger capital management debate, but for today we'll focus on buybacks.
The idea is simple, by repurchasing its own shares, the number of outstanding shares on the market is reduced for a company. When this happens, the relative ownership stake of each investor increases because there are fewer shares, earnings per share increases and this is generally followed by a spike in the share price.
While I understand the theory of buybacks, they rarely work out in the best interests of investors. Generally, buybacks represent an artificial, short-term method of boosting profits, and/or make shareholders feel good.
Buybacks are usually accompanied by the statement, "We don't see any better investment than in ourselves." Although this can sometimes be the case, this statement is not always true.
What's the problem
The problem with buybacks is they tend to be pro-cyclical, in other words, companies tend to use the cash generated at the top of the cycle to buy shares in themselves when share prices are most expensive.
Don't believe me? Take a look at the chart below that shows Qantas' share price over the past couple of years. The company's share price is $3.92, up 260% from December 2013. The share price of Caltex is $35.90, up 150% since February 2011, when you could have bought Caltex shares for around $14.
The reason these two companies have shown this rise in their share price is cyclical – falling oil prices.
For Caltex, lower oil prices mean higher gross retail margins which are being easily absorbed by consumers. In December the Australian Competition and Consumer Commission reported that the gross retail margin had increased to 11.8 cents per litre which was close to a record high.
For Qantas, jet fuel is a major expense. Lower oil prices means higher operating margins and increased profits.
Oil prices are currently trading at 12-year lows, with Morgan Stanley predicting that they could fall around another one third from here to trade around US$20.
So, it's not hard to see that both companies operate in an industry vulnerable to events beyond the control of management, and as sure as night follows day, when the price of oil goes back up, it will eventually derail their current levels of profitability.
In the meantime, investors can thank their boards for buying some very expensive shares in their own companies.
Oh! It would be remiss of me not to mention the $80 million plus buyback at Seven Group Holdings. In this situation, the company is putting additional debt on its balance sheet to buy back about 16.6 million shares. Borrowing money to buy back shares is another example of capital mismanagement by companies that should know better.
Here's an idea, instead of wasting money on buybacks when the cycle is at its peak and the share price is expensive, why not squirrel away some cash for when the cycle bottoms out.
