Buybacks provide positive buzz

CanWest News Service
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But if insiders are selling shares, this could be a red flag

Conventional wisdom has it that share buybacks are a clear sign management has a rosy view of the company's prospects and thinks its shares are undervalued.

Conventional wisdom has it that share buybacks are a clear sign management has a rosy view of the company's prospects and thinks its shares are undervalued.

But is that always true? A closer look reveals there can be other motives at work, including propping up a lagging stock or fending off a takeover.

Companies usually buy back shares by purchasing their stock on the open market, but they can also solicit them from shareholders through a tender offer.

In such a case, the company almost always offers a premium over the market price and shareholders have the option to submit none, some or all of their shares for repurchase.

It is unusual for a company not to offer a premium, although this can happen with thinly traded shares.

To buy back shares, companies use cash on hand or incur debt. The repurchased shares can be cancelled or held for resale.

Buying back shares is usually not the first choice for idle cash, said Lawrence Kryzanowski, who teaches at Concordia University's John Molson School of Business, where he specializes in finance, investing and portfolio management.

"There is a pecking order for the use of cash," Kryzanowski said.

On the top rung are capital investments in plants, equipment or acquisitions.

Then comes returning money to shareholders through dividends or a buyback.

On the bottom rung is investing cash in short-term vehicles such as treasury bills.

Buybacks return value to shareholders because the relative stake of each investor increases when there are fewer shares outstanding.

Buybacks, therefore, tend to create a positive buzz around a company's stock, pushing up its price.

They also improve some key financial ratios, including earnings per share, known as EPS. Fewer shares and the same earnings mean a higher EPS ratio.

Unscrupulous company executives whose compensation is tied to these ratios could therefore use share buybacks to their advantage.

The same goes for insiders or option holders who might take advantage of a short-term bump in share price to sell some of their holdings or exercise options.

So how can the average investor tell whether a buyback is really creating value?

"It's hard to tell if (management or insiders) are feathering their own nest," Kryzanowski said. "I wouldn't be surprised if it's done."

He suggests doing some homework using the SEDAR website, which has electronic versions of documents relating to Canadian public companies, including financial and proxy statements and reports on trading by insiders (directors, senior officers and significant shareholders).

Proxy documents state how management is compensated and what kinds of options are outstanding.

However, insiders are not the only ones to gain from a temporary jump in a share's price. Hedge fund managers have been known to bully management into buybacks.

"They are only interested in short-term gain," Kryzanowski said of these funds, an increasingly influential force in markets.

Jeffery Lusher agrees hedge fund managers can carry a big stick when it comes to forcing buybacks. He's vice-president and regional director for investment at BMO Harris Private Banking in Montreal.

"They put a lot of pressure in general on companies to be more focused about what they are doing with their cash," Lusher said. "Long holding managers are less vocal."

Lusher said the rate of buybacks has increased in the past decade, but does not think questionable motives are behind this trend.

Rather, the increase in Canada can be traced to the fact a lot of companies have matured, are throwing off more cash, carry less debt and have reached a point where expansion has become more difficult. Canadian National Railway Co. is one such firm, he said.

But Lusher did point to one use of buybacks unrelated to returning value to shareholders: fending off takeovers. That's because a company sitting on less cash is a less attractive target. That's especially true if a company takes on debt to buy back stock.

Kate Warne is Canadian market strategist for the investment firm Edward Jones.

She doesn't think investors should blindly applaud buybacks.

Management compensation tied to ratios like earnings per share can create a "misalignment between the interests of management and individual shareholders," she said. Retail investors should dig into company information to look at real earnings growth.

Shareholders should also scrutinize buybacks by companies that use stock options heavily, Warne said. "You see many of the technology companies using buybacks to offset share dilution," she said.

Organizations: Concordia University, John Molson School of Business, BMO Harris Private Banking Canadian National Railway Co.

Geographic location: Montreal, Canada

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