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This tactic may look like sleight of hand – but it actually makes you richer

FTSE All-Share
FTSE All-Share

Managements across Britain are so fed up of the lack of demand for their companies’ shares that they are using their 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 that are 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 5pc or more in 2023, largely as a result of share buybacks. Over three years, 27 companies have bought back 10pc or more of their shares. Last year, around one in eight London-listed smaller companies bought back shares.

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

Why is it happening? What does it tell us about the London market? And is it good or bad for investors?

Understanding buybacks

A company has a number of choices about what to do with its profits. It can reinvest for future growth, perhaps via 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 pays 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 they would rather have the money as a dividend. I disagree. I say investors should think in terms of total return – income plus capital growth.

If you do want income, simply sell some of the shares. This is actually more tax-efficient for many investors as income is typically taxed at a higher rate than capital gains.

Investors have mixed views

Buybacks are often criticised as being a sleight-of-hand way to reward management, who are often given bonuses on the basis of the company’s earnings per share (EPS). If a company buys back shares, those earnings per share automatically rise. If they pay a dividend they do not. This can inflate management remuneration.

In addition, some companies (wrongly in our view) pay management in part with new shares and then exclude the cost from their “underlying” EPS figures, which can artificially flatter earnings and negate the benefit of buying back shares. So we do 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 share price is high. Buying back shares at an elevated price benefits the shareholders who sell but is to the detriment of long-term holders.

We are perfectly comfortable seeing British companies buy back their shares when they are as cheap as they are today. Our focus is on identifying companies that make a high return on capital and generate strong cash flows. These traits give companies multiple different options.

If buybacks attract mixed views, what do the data suggest? Research shows that since 2016 the top 20pc of companies in the FTSE SmallCap index by “buyback yield” – those that spent the most on buybacks as a proportion of their market value – have delivered around twice the total return of the index as a whole.

What this says about the market

What does all this tell us about the London market today? Everyone knows 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 2008-09 and similar to depths plumbed at the height of Covid anxiety in 2020.

Smaller companies are especially cheap, despite the fact that smaller companies have historically outperformed their larger counterparts by a massive margin.

Data from Numis, the broker, show that if someone invested £1,000 for a newborn in 1955 in smaller British companies and reinvested dividends, by the time the baby had grown up and retired in 2022, aged 67, their pot would have grown to £9m. Investing in larger British companies over the same period would also have multiplied your wealth, but to just £1m.

Smaller companies 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 Britain 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 invest in or are interested in.

No one knows these companies as well as the people who run 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 smaller companies and for the London market as a whole.

That market will recover, I am sure. When it does it could bounce back sharply, like a coiled spring unwinding. Buybacks are a signal of the value building in British stocks and should be embraced.

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Mark Niznik is co-manager of the Artemis UK Smaller Companies fund.