Several of our companies are accelerating their share buybacks

I say “effective” because, despite a 2% tax on the market value of net shares repurchased by a company in Canada (a 1% tax in the United States), these share buybacks allow companies to return part of their excess capital without creating any tax impact for their shareholders, unlike a dividend.

The logic behind share buybacks is simple. To understand it, let’s take the example of a private company with, say, ten partners, each owning a share representing 10% of the company’s shares (10 shares in total, one share owned by each). If the company generates net income of $10 million per year, that means $1 million in profit per share.

Now imagine that one of the company’s shareholders decides to retire and wants to sell his share. Suppose also that his departure will have no impact on the company’s net income, which would remain stable at $10 million, and that the company has the required liquidity to proceed. The repurchase by the company of the departing shareholder’s share would reduce the number of company shares to nine. The subsequent profit per share would therefore increase by 11.1% thanks to this buyback, i.e., $10 million divided by the nine remaining shares. Each shareholder thus becomes wealthier, even though the company’s profits have not changed.

This example is simplistic, and reality is more complex. It is rare, for example, that the departure of an owner has no impact on the company’s activities, especially for a private business. Moreover, the example does not consider the cost of financing needed to repurchase the retiring shareholder’s shares. Thus, the increase in earnings per share for the remaining shareholders would likely be lower than 11.1% but would nevertheless remain positive.

For a company, the decision to repurchase its own shares depends on a few key factors. The first is the ability to finance these buybacks. In my view, a company should not repurchase shares if its financial situation is already precarious or if such buybacks could put it at risk. I believe that share buybacks should primarily serve to use a company’s excess capital.

The other key consideration is the price paid for the repurchased shares. If, in the previous example, one accounts for the price paid and the cost of financing related to the repurchase of a share, shareholders must decide. Obviously, share buybacks are much more attractive for remaining shareholders when they are carried out at a reasonable valuation; they become less attractive when the valuation is high.

This long preamble on share buybacks is to say that I am noticing an upsurge in share buybacks among several companies we hold in our managed portfolios. I will mention only a few examples among our Canadian holdings, even though several of our U.S. and international companies are also repurchasing significant amounts of shares. Here are four examples:

For my part, such buybacks indicate at least two things: these companies are in excellent financial health and have excess capital, and their executives consider their stock to be reasonably valued, if not attractive.

Philippe Le Blanc, CFA, MBA 
Chief Investment Officer at COTE 100