THE LATEST front in the ongoing critique of the Anglo-Saxon bonus culture has been opened up by the economist Andrew Smithers, in his recent book The Road to Recovery. He argues that it has led companies to under-invest, thereby harming economic growth.
According to this argument, bonuses give managers a greater incentive to boost their personal wealth through share buybacks rather than by investing in risky projects which – if they pay off at all – will do so only in the long term. While companies can return surplus capital to shareholders by way of dividends or buybacks, Smithers thinks the latter is the problem. This is presumably because managers see dividends as a fixed cost over which they have little discretion; they have to decide what to do with unused cash only after dividends have been paid.
Data presented in his book certainly seems to support Smithers’s thesis. It carries a particularly striking chart showing that companies have been the only net buyers of equities in the market over the last 20 years. But is Smithers telling the full story?
Prodded by a client, we used our proprietary Quest database and equity analysis tool to look for the culprits in the UK. To do this, we ran a screen for companies whose share count had fallen by more than 2 per cent a year for the last three years, the last five years and the last 10 years. While 2 per cent is a somewhat arbitrary number, it struck us as being low when measured against free cash flow yields and dividend yields. We expected to get a long list of stocks which we would have to whittle down by raising the 2 per cent bar and removing anomalies. So we were surprised when the screen yielded a measly seven companies from our UK universe of 508.
The companies that stand accused are (in order of size) AstraZeneca, Next, Stagecoach, Cairn Energy, WH Smith, Micro Focus and Character Group.
Cairn Energy can be dismissed: its share buyback was a one-off event following the sale of its Indian unit.
Next and WH Smith operate in a mature industry, where they generate more cash than would make sense to reinvest in their core business, and we can assume that shareholders would rather not see them diversify. AstraZeneca is representative of a cash-generative industry which has struggled to find new investment opportunities. Micro Focus does reinvest – mainly in acquisitions, as the core business is mature – but produces such prodigious cash flows that it has to buy back shares as well.
The only two that could justifiably be accused of buying back shares rather than reinvesting are Stagecoach and Character Group. The former represents an industry charging the highest transport fares in Europe on the most crowded commuter trains. A bit of investment would be welcome. The latter, with a market cap of £48m, is tightly-held, successful, with no interest in growth. Tiny, it is unrepresentative.
Capex has undoubtedly fallen in the recession. But our analysis shows that companies have been hoarding cash rather than handing it back to their owners. Ageing equipment, pricey equity valuations, and growing confidence should ensure that it is spent on capital equipment from now on.
PJ Davies is head of Quest at Canaccord Genuity.