Matthew Tillett and Mike Shrives, UK value specialists at Premier Miton, explain why share buybacks can be an important tool for capital allocation – and argue Grafton, the Irish trade merchants, offers a perfect example of this.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Share buybacks as an important tool for capital allocation
All industries ultimately mature. Growth converges to that of the general economy and new innovations replace products and services once deemed essential. This is the nature of the capitalist system.
For shareholders, it is important that a management team can safely steward the capital of a business across the rocky waves of cyclical ups and downs as well as industry change. This is important even when growth normalises to a pedestrian pace or turns negative.
Putting capital to work at compelling risk-adjusted returns requires comfort and skill in dealing with imperfect information. Whether it’s building a new factory, opening a new store, or writing a new piece of software. This skill all starts with the concept of value.
What is one project or investment or business worth vs. another? What are the opportunity costs of deploying capital in one direction vs. another? What are the execution risks?
Management teams that fully grasp this concept can take advantage of inefficient public markets by buying shares from shareholders that are willing sellers at prices far below intrinsic value, leaving remaining shareholders with a great deal more of the pie.
While this should be common sense, it is surprising to us how many management teams don’t see it this way. For example, the decision on whether to buy back shares is often driven by the perception of ‘what the market wants’, rather than whether it makes economic sense for the company to do it.
Value investing and exploiting market inefficiencies
David Einhorn, the well-known American value investor, recently suggested (in an interview on the Masters in Business podcast with Barry Ritholtz on Bloomberg Radio) that traditional value investing has become increasingly difficult because the rise of index funds has made the market-correcting process less potent.
‘Value is just not a consideration for most investment money that’s out there,’ Einhorn said. ‘Passive investors have no opinion about value. They’re going to assume everybody else’s done the work.’
This lack of market efficiency means value-orientated investors have had a frustrating time as many profitable old economy businesses with lower growth profiles languish at low valuations for extended periods of time.
We sympathise with this view and believe that management teams can go some way towards addressing the problem if they understand that increasing intrinsic value per share should be their north star.
Are share buybacks a UK-specific opportunity for value-oriented investors?
In the UK, where we have less disruptive growth businesses in the stock market indices, this frustration has been magnified.
Many observers have pointed to the wide differences in valuations at an industry level in the UK vs. the US.
One solution is that management teams use this market dislocation as an opportunity to increase value per share when opportunities to grow a business organically are harder or carry more risk. Well-timed share buybacks could be the answer.
The retort from those that prefer dividends is that shareholders can be given surplus cash and choose to buy the shares themselves. The advantage management have in making this decision on behalf of shareholders is that they have access to more information and may be better placed to make a judgment of a business’ intrinsic value.
Often dislocations between price and value come at times when outside investors have a significant information disadvantage, less industry understanding, and perceptions of risk can be skewed by external factors.
There are also considerable tax disadvantages to receiving income and portfolio concentration considerations that may prevent an investor putting their dividends to work when its most advantageous.
Grafton trade merchants: a case study
Grafton, the DIY, builder’s merchant and home and garden retailer headquartered in Dublin, Ireland, is one business we think is doing a great job of this.
Grafton is a collection of old school trade merchants serving the construction industry, predominantly in the UK and Ireland. As well as its distribution segment, trading under the brands Selco and Leyland SDM in the UK, the business has a leading Irish retail operation under the name Woodie’s and manufactures dry mortar and wooden staircases, as well as several other smaller businesses.
Most of the business, while well-positioned, is in relatively mature markets. Its story is a far cry from the AI-induced hyper growth stories in the headlines today.
Higher interest rates and general cyclical pessimism about construction activity have driven the valuation down to a level that is low by historical standards, despite a very robust balance sheet and a highly cash-generative business model.
Management have rightfully recognised this by returning £343.3 million to shareholders via share buybacks over the period between May 2022 and December 2023, a 16.8% share count reduction, while continuing to pay an attractive dividend. And because the shares have been bought at such a low valuation, this has provided a nice boost to the per share value of Grafton.
This, in turn, has helped the shares to rally over 40% from the lows seen in October 2022, despite the company itself experiencing difficult trading conditions in several of its end markets.
Grafton is not an exception in the UK equity market. Increasingly, more and more management teams are recognising the power of share buybacks in enhancing per share value at a time when UK equity valuations remain notably depressed.
Even if the long-awaited recovery in the valuation of UK equities does not materialise, the process of companies acquiring their own shares at low valuations may still create a lot of value for investors who retain their exposure.
What are share buybacks and why do some companies deploy capital in this way?
One of the features of a profitable business model is the generation of surplus capital. Once all the bills have been paid, there is an amount of cash left over that can be used for other purposes. A share buyback is one of the options available to company management (other options include organic growth investment, acquisitions, and dividend payments).
A share buyback involves a company buying back a portion of its outstanding shares. The aim is to reduce the number of shares available on the open market. The financial impact of a buyback is to increase the per share metrics, such as earnings per share. This should, in turn, increase the per share value of the company.
The price at which share buybacks are undertaken can make a big difference to the value creation that accrues to the company’s long-term shareholders. If the buyback occurs at a price substantially below the underlying intrinsic value of a company, then this may have an outsized positive impact on future returns, if the share price does eventually increase towards the intrinsic value.
We show below a simplified example of how such a situation might play out over a four-year period. We assume half of the company’s earnings are allocated to a share buyback while the other half are retained for organic investment that results in 5% annualised earnings growth. We assume that the fair value of the company is 12x price-to-earnings (p/e), compared to a current assumed 8x multiple.
If the p/e valuation multiple were to increase by one multiple point every year, eventually converging on 12x by year four then the total return would be an impressive 127%, or 23% annualised.
Note that even if the share price valuation were to remain on a lowly 8x p/e multiple, the total return would still be a respectable 58%, or 12% annualised, which is well ahead of the 5% annualised earnings growth due to the accretive impact of the share buybacks reducing the share count.
While this is entirely theoretical and certainly not a forecast, there are currently many examples of UK-listed companies that are trading on single digit p/e multiples while delivering respectable earnings growth and buying back their own shares. Long term investors are likely to be well rewarded by owning such companies in their portfolios.
Impact of share buyback on share price total return
Source: Premier Miton Investors. For illustratice purposes only.
