Throughout the past 20 years buybacks have become an increasingly popular way for senior management to use excess free cash flow generated from business activities. By reducing shares outstanding, buybacks increase the percentage ownership of ongoing shareholders. Unfortunately, buybacks do not treat all shareholders equally.
Buybacks do not carry the same level of commitment as dividends and can be cancelled without the same severity of negative consequences that follow a dividend cut. While in certain circumstances buybacks may be beneficial, they require that management effectively time the market and purchase their shares at a favorable price relative to expected fair value.
Examining the history of buybacks, we can see that companies often implement share repurchase plans when stock prices are higher rather than lower – effectively rewarding selling shareholders, while ongoing shareholders are punished. More concerningly, buybacks are often used to accumulate stock for executive option plans – it is advantageous for executives to buy back stock when prices are high as option strike prices are often considerably lower. Consider the negative impact, for example, executive options to purchase shares at $50 that were recently bought back at $100.
Buyback policies are not consistently aligned with the interests of all shareholders and are often poorly timed. The graph below highlights how recent market volatility has impacted buyback plans in the U.S. market – decreasing over 50% since March. In theory, the market selloff would have been an ideal time to repurchase shares for companies with excess cash reserves; however, the exact opposite occurred.
Bristol Gate invests in companies with growing dividends and a long dividend-paying history. By committing to a dividend policy, our portfolio companies signal a long-term commitment to shareholders by treating all equally. Bristol Gate’s US strategy has achieved an annualized dividend growth rate of over 20% since inception by investing in companies with remarkable ability to increase free cash flow and with strong management teams committed to sustainably returning excess capital to shareholders.
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