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An unholy alliance in the world of share buybacks.

Summary: In the English-speaking world, the central banks' great bond market rigging adventure is winding down.

In the English-speaking world, the central banks' great bond market rigging adventure is winding down. In the equity market, by contrast, the anglophone corporate sector is rigging furiously. It is not always widely appreciated that non-financial companies have been the dominant buyers of US and UK equities since the mid-1980s thanks to takeovers and, increasingly, share buybacks. This is worrying because on long-term measures of value such as the cyclically adjusted price/earnings ratio, equities are very expensive. There is also a risk that capital investment is being crowded out by buybacks and dividends, while balance sheets are saddled with increased debt. One outcome of the central banks' bond rigging, in other words, is that companies are borrowing cheaply to buy expensively. Buyouts are approaching the record levels reached in 2007 before the market crash. The postscript to that earlier episode was that corporate boards did not seize the opportunity to buy furiously when the market was at its nadir in 2009.

At this point buyback apologists tend to argue that there is a strong correlation between companies that shrink their equity through buybacks and those that produce above average returns to shareholders.

Well, of course the returns are high over the short to medium term, because buybacks artificially push up the share price and earnings per share. That reflects an unholy alliance between shareholder activists, with Carl Icahn to the fore, and chief executives whose pay is linked to earnings per share or total shareholder return. Such financial engineering, if that is not an unduly flattering description, amounts to an easy win for these two groups. In effect, the chief executives are incentivised to take extreme risks with their market share in the knowledge that their tenure is so short nowadays that a collapse in competitiveness will be their successor's problem. For their part, the activists will have long quit the field when the cost of their activism becomes apparent.

That does not mean that all buyouts are bad. They are essentially a capital allocation decision. A company in the mining or energy sector may be better off deferring investment after the capital expenditure binge of recent years and the subsequent downturn. Depending on the level of the share price, the question is whether to return money to shareholders via dividends or a buyback.

Even with growth companies it is possible to have more cash than can be absorbed by capital expenditure. That is true of Apple, the technology company, where Mr Icahn's campaign for buybacks makes sense. But for the non-financial corporate sector as a whole, the game disadvantages the ultimate beneficiaries: pension scheme members.

Last year, Larry Fink, chief executive of BlackRock, the world's largest fund company, worried publicly about under-investment and short-termism arising from buybacks. Interestingly, few other fund managers have followed suit. That highlights another conflict of interest. Too many have similar incentives to the chief executives.

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Publication:The Daily Star (Beirut, Lebanon)
Date:Jun 22, 2015
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