12.10.2018 - Comments

Weather for buybacks?


When Warren Buffett breaks with his principles, the weather on the capital markets must be extraordinary. Normally, the oracle from Omaha rarely makes share buybacks and has strict rules when they are eligible. But recently he announced that he would break his self-imposed rules and make buybacks, even if the conditions were not met.

What is so special about share buybacks?

A company acquires its own shares on the capital market and subsequently cancels them. As a result, there are fewer shares among which the profit is distributed. The pie remains the same size, only the number of pieces into which it is cut is reduced. As a result, the shares must become larger, i.e. the share price must rise.

Sounds good for now. What's the catch?

The problem with share buybacks is that money is spent but no new assets are acquired. Only a higher share price is bought, but no goods are purchased that could generate future earnings. The money is permanently gone, but the higher share price could only be temporary.

Therefore, share buybacks should only be a last resort. Before this measure is taken, all investment and acquisition opportunities must be exhausted and the balance sheet must be solid, i.e. the cash register must be sufficiently full and debts largely repaid.

Share buybacks by major German companies are currently heading for a new 10-year high. 5.7 billion euros have been invested in current buyback programs and a further 7.0 billion euros have already been announced. The current buyback programs therefore amount to EUR 12.7 billion. It cannot be ruled out that further companies will join in and that the total volume will increase even further.

Why do German companies currently choose to buy back shares and against investments, acquisitions, debt repayment or a special dividend?

A look at the market situation reveals that investment activities were not particularly high recently, while companies were more likely to make acquisitions. However, in view of advancing digitalization, artificial intelligence, autonomous driving, etc., the question arises whether the range of investment opportunities has really been exhausted. Only those who invest sufficiently in new strategies, technologies or personnel have the chance to harvest the fruits later. Are we perhaps dealing with a lack of economic creativity?

Paying a higher temporary dividend is not a popular option. In any case, it would first have to be approved by the annual shareholders' meeting, which takes away management's flexibility. Nor do investors want dividend payments to be volatile.

The low level of interest rates has caused bond prices to rise sharply and significantly reduced the interest burden. Early repayment of debts is therefore either expensive or does not bring any particular financial relief.

It seems that share buybacks are the right thing to do. It will be interesting to see how many more companies will join the ranks and make share buybacks. The last buy-back peak was reached in 2008 at EUR 16 billion. At that time, just before the crisis, the company's own shares were acquired at top prices. Shortly afterwards, prices collapsed. Liquid funds were then lacking and some companies even had to raise new capital, i.e. dividing the cake into even more pieces. A less favorable timing for buybacks was hardly conceivable in retrospect.

So we can only hope that Warren Buffett correctly assesses the weather situation on the capital markets and that the current market environment is actually ideal for share buybacks. As long as this goes well, companies and investors enjoy a bigger slice of the cake and higher stock prices.

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