11 Dec 2023
Nick Shenton, Fund Manager
Through share buybacks, some of the best companies in the UK market are delivering compound growth in their earnings per share – and so rewarding their patient shareholders.
In recent years, a string of unusual developments caused UK equities to become one of the least popular items on the investment menu. Now, however, something is happening to make them much more appealing. Unnoticed by disinterested capital markets, companies are deploying their surplus cashflows to buy something that is both cheap and familiar: their own shares.
UK companies are eating themselves. And this is not a light starter nor a selection of tapas plates, but rather a hefty main course with all the trimmings. These share buybacks are happening on a scale that neither I nor any of my colleagues have ever seen before.
Share counts of some UK companies have shrunk dramatically in recent years
Source: Bloomberg, Artemis as at 20 September 2023. (Share counts rebased as at 31 December 2020).
“If you won’t buy our shares at this price, we will!”
Many investors treat share buybacks with scepticism. This is understandable if valuations are high. And it’s understandable if management are focused on driving short-term momentum in earnings per share at the expense of reinvesting in the business to create long-term value for its shareholders.
But that is not what is happening here.
Companies must reinvest to sustain and enhance their competitive advantage. Once this is done, however – and after all stakeholders have been fairly paid – the leftover capital is surplus. This surplus should then be deployed to create the maximum long-term value for shareholders.
There are, of course, assorted options for how best to do that. Any executive worth their salt should have a clear view of how to compare and contrast the prospective returns from these competing choices. At the moment, a significant number are looking at the compelling returns available from reducing their share count and simply saying “if you won’t buy our shares at this price, we will!”
To state the obvious, share buybacks work best when a company’s shares are cheap relative to its earnings. And that’s precisely what we see today: the UK stockmarket is on sale. It trades at one of its lowest-ever valuations relative to both its own history and relative to other stockmarkets around the world. Put simply, by buying back shares, companies are purchasing their own cashflows at a very attractive price. For a more detailed view, let’s consider the case of Good Co…
How share buybacks deliver returns to patient shareholders: a worked example
‘Good Co.’ is an imaginary company with 100 shares in issue and £100 of net income. So it generates £1 of earnings per share. With reinvestment largely going through its P&L, Good Co pays out 40% of its net income in dividends and 60% in share buybacks. It grows its net income at 6% per annum.
Despite reinvesting to ensure that its future is sustainable, Good Co is unpopular with investors: it trades at price-to-earnings multiple of just 6x, giving a share price of £6 and a total market cap of £600.
Good Co’s low starting valuation means that, in Year 1, £64 of share buybacks reduce its share count by 11%. Thereafter, as it directs 60% of its net income to share buybacks each year, a powerful but unusual form of reverse compounding occurs:
‘Reverse compounding’ in action – as Good Co buys back shares, dividends per share increase
By the end of this process, Good Co’s share count is 60% lower and its dividend per share has increased by 185%. For its patient shareholders, that means that what started as a generous 7% dividend yield has compounded to a whopping 19%...
If it keeps going, Good Co will have reverse-compounded its way to the ‘golden share’ – the last remaining stock in the company – within eight years.
If cashflows per share rise, then so must share prices. Eventually…
“This cannot happen!”, I hear you shout. “Surely, Good Co’s share price must adjust upwards to reflect the fall in the number of shares in issue!” And we agree… in theory. But this highlights the most perplexing aspect of these share buybacks, which is how little impact they are currently having on share prices. If cashflows per share rise year-in, year-out, then surely share prices should too?
Yet in the case of the large brigade of UK companies who have been buying back shares, share prices have not been adjusting. That means, illogically, that companies are able to eat into their equity bases with even greater alacrity.
These are far from isolated incidents; in the past 12 months, some 57% of our portfolio by value has bought back shares.
To reiterate, the share of a company’s profits that accrues to its remaining shareholders increases every time its share count falls. If this carries on, the transfer of wealth from price-insensitive sellers to patient shareholders compounds exponentially until the golden share is reached. Think about it: we and our patient co-investors own progressively more of these companies without spending a single penny. And as for the ‘golden share’? Seven years may seem a long time, but in multiple cases we are already more than two years through that process.
Do we really expect to be the last remaining shareholder in BP? Or in NatWest? Clearly not. But the most likely reason that won’t happen is that the share prices of these companies move up – significantly – when the world takes notice. The increase in demand for the shares will then be met with a rise in the share price.
Can UK companies really continue to grow cashflows and buy back shares?
I can hear your objections. “But wait! The UK economy isn’t in great shape. So isn’t the prospect of these companies continuing to generate surplus cashflows open to question?”
Yet while this has been the dominant narrative since Brexit, it has not been borne out by reality. Not only has the UK outperformed Germany and France on a GDP basis since Brexit was finalised in late 20192, but 75% of the FTSE 100’s revenue comes from outside the UK3.
We recently met Pearson, one of our long-term holdings, and discussed its English Language Learning division (as well as their buyback of 5% of the company’s equity). The Italian head of this business, Gio Giovannelli, lived in Brazil and is leading investment in test centres in India for emigrants seeking to move to Canada to work for US tech companies. If that’s not global, what is?
Stockmarkets are discounting mechanisms, and although they should be logical, emotions and misleading narratives often mean that logic breaks down. That presents an opportunity. The UK has a wealth of well-run, profitable companies with strong balance sheets and global opportunities. But they are currently being priced like they are challenged UK domestic businesses.
Take Next, for example. It is viewed as a challenged UK high street retailer, but it generates 65% of its revenue digitally and has overseas growth opportunities for its popular core brand and for recently acquired businesses such as Reiss, Fat Face and Joules4.
Or look at Tesco, whose 4% dividend yield is growing at 5% from share buybacks alone, and which has more market share online than offline. Tesco Whoosh operates out of more than 1400 sites, offering rapid delivery services to more than 60% of the UK population (worth noting in case all this talk of eating renders you hungry)5.
In our minds, this all adds up to making the UK stockmarket one of the most interesting items on the global investment menu. For now, prospective buyers have yet to be tempted. But as time goes on, and they begin to notice the beneficial compounding effect of significant buybacks have on a cheap market, we believe that will change.
Fortunately, investors in equity income strategies are being paid to wait for that change – and paid handsomely given the dividend yields on offer these days. Reinvesting those dividends multiplies the impact of share buybacks and intensifies the effect of compounding. While most investors have, unlike the companies themselves, yet to regain their taste for buying UK equities, we believe they could soon become the dish of the day.
1Artemis/ LSEG Datastream
2Revisions show UK economy no longer the post-pandemic laggard | Reuters
3Bloomberg London on Cusp of Becoming Biggest Stock Market in Europe, Again - Bloomberg
4NEXT plc. Interim results, 2023. half-year-results-july2023.pdf (nextplc.co.uk)
5Tesco plc. Interim results – analyst call hy2324-analyst-transcript.pdf (tescoplc.com)
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