Letter number 148 of February 2023
- QUESTIONS & COMMENTS
This is what the vast majority of citizens or journalists think , while the response of scientific research, which has been looking closely into this subject for decades, concludes, at best, with a marginally positive and insignificant answer.
Without providing absolute and definitive proof, below is the performance of the IBM share price over the last 10 years:
This is a 30% decline in share price compared to a 216% rise in the S&P 500 Index since 2012, despite IBM buying back 20% of its shares in 2012.
Another example is L'Oréal, which announced the buyback of 4% of its capital from Nestlé on 7 December 2021 at €400, i.e. at a discount of 5.8% to the closing price and 2.9% to the average price over one month. If the thesis of share buybacks driving up prices had held, L'Oréal's share price should have outperformed the index, since the buyback was at a significant discount to the stock price. However, four months later, L'Oréal's share price is down 15% while the CAC 40 is only down 5%.
So the subject is not self-evident.
For example, researchers Dimitris Andriosopoulos and Meziane Lasfer estimate that the announcement in France of a share buyback programme propels the share price by 0.8% more than it would have been without this announcement. In other words, the thickness of the line when one considers average daily price variations is around 1% in absolute value.
How can we explain this discrepancy between the facts and what most people feel?
Firstly, people often think that if there is one more buyer in the market, it naturally pushes the price up, for example from 100 to 102. They don't necessarily see that if it goes from 100 to 102, investors who weren't selling at 100, but are selling at 101, will then start selling stocks, which they wouldn't have done if the price had stayed at 100, and which will bring the price back to 101, or even 100.
Secondly, because share buyback programmes are most often announced at the time of results (of the sale of an asset, an external growth operation, etc.). It is therefore impossible to distinguish between the possible rise in the share price, which is due to the announcement of the share buyback, and the other, often more revealing, element of the company's situation, which is often positive since share buybacks aren’t announced when the company is making losses or underperforming.
On 1 February 2022, UBS's share price rose by 8% following the announcement of its highest annual results in 15 years and a 35% increase in the dividend. However, it also announced a $5bn share buyback in 2022, double that of the previous year. What is driving the share price up? The results, bolstered by the signal of a sharply rising dividend, or the share buybacks?
There is a Chinese proverb that says: "When the wise man points at the moon, the fool looks at his finger". Here the naive person sees the rise in the share price and attributes it to the share buybacks, not to the good results that made them possible...
Thirdly, most people, with the exception of specialists, are unaware of the fact that companies don’t just buy back shares at will by raiding the market. In Europe, the volume of shares that can be bought back is limited to 25% of the daily trading volume of a company’s shares, and at a price that is lower than the last quoted price, or lower than the best buy order available at the time . A purchase under these conditions cannot therefore technically raise the price when it is executed, but will instead lower it.
Furthermore, the issuer may not buy back its own shares when it holds inside information and as long as it is not made public, nor may it do so in the 30 calendar days preceding the publication of its annual, half-yearly or even quarterly results.
Fourthly, one can fall victim to the EPS illusion that an increase in EPS is necessarily accompanied by a parallel increase in the share price, as the P/E ratio, which links the two (share value = EPS x P/E), is stable . However, with still low interest rates, say less than 2% after tax, it is sufficient for the share's P/E ratio to be less than 50 (i.e. the inverse of the after-tax cost of financing) for the share buyback to be accretive to EPS. Using this criterion, only for Tesla and Hermès would a share buyback be (slightly) EPS dilutive, since their P/E ratio is around 55!
One possibility is that the buyback is insignificant, as are most buybacks of 1, 2, or 3% of the share capital, in which case the impact on EPS and on the company's financial structure is small. The constancy of the P/E ratio can be postulated and the share value will hardly move, see the + 0.8% of the study mentioned above.
Another is that the share buyback is significant, more than 5% of the capital, and the impact on EPS and the financial structure will also be significant. To postulate that the P/E ratio is constant when the share has become riskier due to a more debt-laden financial structure is to delude oneself. There is no reason for the P/E to remain stable since the risk taken by shareholders, due to a financial structure with more debt, has naturally increased. A higher EPS is matched by a lower P/E ratio and therefore an almost unchanged value, as many researchers have shown, including those mentioned above.
CAC 40 share buybacks over the last 10 years
This is illustrated by a study of share buybacks on the CAC 40 over the last 10 years. If share buybacks had the capacity to push prices up, we should see CAC 40 companies who buy back shares frequently and in large volumes, outperform the others.
This is not the case.
Of the 14 such companies, half (7) outperform the CAC 40, and the other half (7) underperform. And if we take the top 20, the match is not significantly different (8-12):
Don’t confuse the finger with the moon
The fact that L'Oréal, the French group that conducted the most share buybacks between 2012 and 2021, outperformed the CAC 40 over this period, +346% compared to +120%, is the result of its net earnings growing by 60% over the period, not because it bought back shares. And the fact that Sanofi, the French No. 2 in terms of share buybacks, underperformed the CAC 40 from 2012 to 2021, +57% compared to +120%, is the result of its net earnings only growing 27% over the period, not because it didn’t not buy back shares.
In fact, among the top 20 CAC 40 companies in terms of share buybacks, the average earnings growth of those that outperform the index is twice as high as that of those that underperform it.
As with many things, we should always avoid confusing cause and effect.
 "The market valuation of share repurchases in Europe", Journal of Banking and Finance, June 2015, vol. 55, pages 327-339.
 AMF, "Guide to intervention by listed issuers in their own securities and stabilisation measures", DOC-2017-04.
Based on the work of Paul Schmelzing, which you can consult here, combining mainly European sources, this graph shows a continuous decline in real interest rates, probably the result of a much better allocation of capital that the development of financial markets has allowed over time.
We draw the attention of our young readers to the fact that in finance, it is always dangerous to extrapolate a curve, even if it is 700 years old!
Moreover, the few financial elements that we have from Greco-Roman antiquity show real interest rates lower than the 15% of the beginning of the 14th century.
With Simon Gueguen, lecturer-researcher at CY Cergy Paris University
Identifying the criteria for choosing a company's capital structure, and in particular the right mix of debt and equity financing, is the Holy Grail of corporate finance.
Several competing theories have emerged since the neutrality principle established by Modigliani and Miller in 1958 . One of the most widely used is the trade-off between the tax benefits of debt and the costs associated with the risk of bankruptcy if the company experiences financial stress. While conceptually useful, this approach faces practical difficulties. On the one hand, the tax benefit of debt is actually quite small. On the other hand, the problems associated with financial stress are difficult to measure empirically. On the latter point, a recent paper uses an exceptionally accurate database from Sweden to show that financial stress can lead to a rapid flight of talent, and that this risk is an argument against debt in the capital structure.
The intuition of the article is based on the idea that it is easier for an employee to find a job when he or she already has one. In the case of a company in difficulty, employees with particular skills, who are a priori the most likely to find a job quickly, would be the first to jump ship. If this is the case, then their departure is an element of the financial stress cost set out in the trade-off theory.
Empirically, measuring this effect requires a detailed database, containing not only information on the financial health and liability structure of companies, but also and above all, detailed data on employees (age, qualifications, seniority, salary, 'skills', etc.). To achieve this, Baghai et al cross-referenced several sources in the Swedish market. They used longitudinal data on individuals collected between 1990 and 2011, allowing them to follow their careers over the long term. They were able to cross-reference this with data from the military: until 2009, young Swedish men had to undergo not only physical, but also cognitive (logic and comprehension) and psychological (emotional intelligence, ability to assume responsibility, etc.) tests. Of course, the results of such tests should be taken with caution. But these data enabled the authors to carry out the study and to obtain very significant results.
The main result concerns the departure of employees identified as 'talented' (with high cognitive and non-cognitive abilities according to military tests) in companies under financial stress. The probability of departure is 65% higher than for other employees. One explanation could be that these employees are expensive and the company takes the initiative to let them go in order to reduce costs. In order to rule out this possibility, Baghai et al verify that these are indeed voluntary departures. On the one hand, in most cases, the employees concerned do not experience any period of unemployment before finding a new job. On the other hand, according to Swedish legislation, companies that want to dismiss for economic reasons must follow the LIFO (last in first out) rule. Talented employees leave before their turn in this queue, which again presumes voluntary departure.
It is then necessary to establish the link between this effect and the choice of capital structure. To do this, we observe departures during unanticipated changes in exchange rates that cause sudden drops in international sales. In this situation, talented employees are much more likely to leave for companies with high financial leverage. Accordingly, focusing on debt as a method of financing leads to an increased risk of talent leaving, all other things being equal. It is not the fundamental economic difficulty that causes the departure, but the financial difficulty increased by the leverage.
Finally, the last important result concerns the effective consideration of this risk in the choice of capital structure. Baghai et al identify the most talent-dependent companies as those that employ the largest numbers of talents, but also companies where talents are highly concentrated in a few units. For these companies, the voluntary departure of talent has very negative consequences and is a significant cost in the event of financial stress. In the sample studied, a one standard deviation increase in talent dependency translates into a 1.1 percentage point decrease in the debt ratio (debt percentage of liabilities), a significant amount compared to an average ratio of 13.3%.
This article is an important contribution to the understanding of capital structures. Among the criteria for choosing the mode of financing, talent retention has probably been underestimated. In addition to providing an assessment of this effect through an exceptionally rich database, the paper identifies a possible reason for the under-leveraging of firms compared to theoretical predictions: the desire to retain talent in times of crisis.
Q&A : Is the cost of capital of a monopoly activity different from that of the same activity in competition?
The cost of capital is linked to the market risk of the business, not its total risk. The fact that the business is a monopoly does not change its degree of volatility and sensitivity to general economic conditions, so it seems to us that the cost of capital is the same whether the business is a monopoly or not.
This should not prevent you, but this is another issue, in the cash flows you discount from testing a scenario where the company loses its monopoly, which would likely reduce some of its free cash flow.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest.
Here are some of our recent comments.
Japan is another world
Kyocera is a diversified Japanese industrial group (industrial ceramics, semiconductor components, automotive parts, printers, solar panels) that holds a 15% stake in the telecom group KDDI, without probably many synergies between the two. But this stake represents 55% of Kyocera's market capitalisation, which is of course penalised on the stock market by this baroque structure. The group is only valued at 4.7 times its operating profit, as long as its industrial activities are valued without taking a discount on the sum of the parts. This shows a contrario that there is one, since an industrial group of this size is not valued at 4.7 times its operating profit.
Kyocera has a particularly healthy debt situation since it lends to banks, to the tune of €2.8 billion. Its board of directors is composed of 13 members, all born before 1963, with one exception, with 8 managers and 5 independent directors, whereas Kyocera's shareholding is made up of institutional investors; not one foreign director and only one woman. At the level of KDDI, not one independent director to take into account the 85% of the capital held by third parties, not one foreigner on the board and only one woman. 14 members, all born before 1966, including 9 managers and 5 representatives of Kyocera.
To the shareholders who asked for an improvement of the governance of Kyocera and the sale of the stake in KDDI, the president answers that it is not possible to sell the participation in KDDI because it will be used as a guarantee for a loan at a reduced rate because of the collateral provided by the KDDI shares, a loan of €3.5bn euros to finance investments. Moreover, as the dividends paid are higher than the interest on the loan, this is good for the shareholders, especially as selling the stake in KDDI would require paying taxes on the capital gain.
This is the accounting illusion of leverage, and it forgets the most important thing, which is the value of KDDI, whose variations can be much more important than the difference between the dividend yield and the interest rate on the debt. As long as management thinks like this, it is unlikely that the discount to assets will disappear.
Société Générale's strange communication on its distribution to shareholders
On the occasion of the publication of its 2022 results, SG announced a distribution policy to shareholders with a dividend of €1.7 per share and a share buyback program of €440m, "equivalent to around €0.55 per share". It is curious to say the least, and in our opinion not intellectually honest, to put on the same footing, in € per share under a "distribution to shareholder", a dividend of €1.7 received by all shareholders and €0.55 per share of share buybacks that shareholders will not receive. Indeed, even the shareholders who will sell their shares and be acquired by SG, unknowingly and by chance (given the daily trading volumes of this share), will not receive €0.55, which is a figure that has no financial significance because it is dividing apples by pears!
Of course, it is nicer to announce €1.7 + €0.55 = €2.25, a calculation that SG does not give and that it is content to implicitly push the reader of its press release to do so, than simply €1.7. But there are limits to the power of communicators, at the risk of undermining their credibility. The only figure that counts in this area is the total sum in M€ of dividends and share buybacks, i.e. 1.8 M€. And here, investors were caught off guard because SG was expecting a rate of return to shareholders of at least 50% as in the previous year. And as the 2022 results were better than in 2021. . . Compared to a 2022 recurring net income (group share) of €5.6bn, a billion is missing.
Not that shareholders are thirsty for dividends or share buybacks, like leeches, but they know that the marginal return on reinvested equity, above the levels required by prudential standards, is currently 2%, i.e. the money market rate, and well below SG's cost of capital. SG has a CET 1 ratio of 13.5%, above these minimums, while BNP Paribas is at 12.3%. As SG is quoted at one third of its book value (€22bn against €66bn), the €1bn not distributed by SG will not result in an increase in value of €1bn, but only of €333m, i.e. a loss of value of €666m. It is therefore easier to understand why, despite good results, SG's share price fell by 5% yesterday, the biggest drop in the CAC 40, in a stable market.
A good lesson for those who have forgotten that a policy of return to shareholders is naturally judged by the returns on marginal investments that the company can make.