Disclaimer
This is a non-independent marketing communication commissioned by Schroder Investment Management. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Anyone who follows the UK investment trust industry will be familiar with the concept of the share buyback as a mechanism for managing the discount between a trust’s share price and its net asset value (NAV). They are a commonly used tool, increasingly so in the current environment in which, discounts have notably widened.
Not everyone is a fan of them, but the economic argument in favour of the buyback is simple and strong. From the perspective of demand, a buyback programme introduces an additional buyer of the trust’s shares which can put upward pressure on the share price. As a secondary impact, the presence of the buyback can also signal confidence in the trust’s underlying assets and strategy, which may attract more investor interest over time, further increasing demand.
Meanwhile, from the perspective of supply, a share buyback reduces the number of shares in circulation for the trust in question, thereby enhancing earnings and dividends on a per share basis. Remaining shareholders are therefore rewarded by owning a larger proportion of the trust as a whole. Furthermore, buybacks only make sense when a trust’s shares are trading at a discount – by definition, this means the investment trust is effectively buying itself back at the price implied by its share price, which is lower than its NAV. This also has a beneficial impact for shareholders, because NAV per share is enhanced. The greater the level of discount, the more value that accrues to shareholders.
On a daily basis, most investment trust buybacks are modest in scale, but if conducted consistently and with discipline, they can have a very material impact for shareholders over time. Taking the maths to an extreme, if an investment trust retires half of its equity over a period, all other things being equal, its earnings and dividends will double on a per share basis. All other things never are equal, of course, but it is difficult to argue against this powerful logic.
A potential strategy for any company
Investment trusts are listed businesses and undertake share buybacks within the framework of UK company law, specifically the Companies Act 2006. This permits companies to repurchase their shares, provided they have the necessary shareholder approval and can meet solvency requirements. The same legal principles apply to all UK listed businesses, and while companies operating in industries outside of the investment trust sector may not need to worry about managing their discount to NAV, management teams are often highly sensitive to their market rating and can utilise buybacks to return surplus capital, improve financial metrics and signal market confidence.
In an environment where most market commentators acknowledge the significant undervaluation of the UK stock market, both in the context of history and when compared to other regions, we should not be surprised to see share buybacks becoming more popular with UK company management teams.
Across its recently completed financial year, some 29 (more than 60%) of the portfolio holdings in Schroder Income Growth Fund plc I have had the privilege of managing since 2011 – conducted share buybacks. This compares with 17 (38%) of the fund’s holdings in the prior year. This is a significant increase, which encompasses a broader range of companies across a wide range of sectors and all sizes.
I believe this is a very positive development – for shareholders in trust and for the UK stock market more broadly – for three key reasons. Firstly, we have a strong preference for businesses with healthy cash flows and solid balance sheets – these types of businesses have the resources to deploy towards share buybacks when the time is right1. Secondly, this is a clear indication that the management teams responsible for the companies in which we have invested have the inclination to reward their shareholders. And thirdly, the increasing prevalence of share buybacks in the UK is a sign that businesses recognise that their shares are undervalued and are increasingly looking to do something about it. As is the case for investment trusts, the more undervalued a company’s shares are, the more value can be created by retiring equity.
Clearing the hurdle
Indeed, it could be argued that management teams should view the returns they can achieve on a share buyback as a “hurdle”, which any other potential use of surplus capital must clear in order to proceed. If the projected returns on, for example, an investment in new facilities or a potential acquisition, are not as attractive as the hurdle rate of return delivered by a buyback, then that particular use of capital should perhaps not be pursued. This would demonstrate good capital discipline.
Ultimately, businesses that have shown such capital discipline in the past have been rewarded for it. One that we have held in the past in the Schroder Income Growth Fund portfolio is the retailer Next. Its management team has consistently demonstrated capital discipline in recent years by using surplus cash flow for a combination of share buybacks (when the shares have been lowly valued) or special dividends (when the shares have been more fairly valued). Between 2000 and 2023, overall group sales growth was relatively modest (5.7% per annum). However, over the same period EPS and DPS grew annually by 12.5% and 10.4% respectively. Good control of costs played a role here too, as did a degree of operating leverage, but a significant part of this per share growth stemmed from the consistent deployment of share buybacks. Share price performance was even more impressive (+15.3% annualised total return), with the valuation of the shares rising as the market increasingly came to appreciate the company’s impressive capital discipline2.
Next isn’t currently held in the Schroder Income Growth Fund portfolio, but we are confident that the successes of the past can be emulated by the many undervalued UK companies that are currently demonstrating a similar degree of capital discipline.
Among them is Shell. As well as delivering a dividend yield of 5.5% to shareholders annually, Shell is currently implementing a $3.5bn buyback programme, having already returned £13.5bn through buybacks over the last 12 months3. Shares outstanding have already reduced by 20% since 2019, which is already making a material difference to the company’s per share financial metrics.
Another example is the mid-cap construction business, Balfour Beatty. Among its many attractive characteristics is management’s consistent capital allocation policy which has delivered £755m in shareholder returns over the last four years through dividends and share buybacks. This represents almost a third of its current market capitalisation. It has retired more than a quarter of its shares in issue during this period and, notably, its share price has more than doubled4.
Other examples of portfolio companies that are currently buying back shares include Unilever, NatWest, Qinetiq, and Lloyds. Indeed, with well over half of the current portfolio’s constituents having bought back shares in the last 12 months, this represents a profound shift in capital allocation decision-making that spans a wide range of sectors and all parts of the market cap spectrum. All, however, are united by their management team’s belief that buying back shares is a disciplined and value-enhancing use of surplus cash flow.
Game changer
To conclude, it certainly doesn’t surprise me to see so many buybacks in the UK currently. It is well observed that the UK stock market is currently undervalued. Indeed, it may represent one of the cheapest asset classes available to investors anywhere in the world.
This is not new news, however, and readers may be becoming bored of being told it. What is new is that the current trend towards share buybacks is potentially powerful enough to ultimately make a difference to this undervaluation. As we have seen from the case study of Next – and many other businesses around the world that have consistently bought back their shares to the benefit of their remaining shareholders – eventually, the market responds.
Perhaps it is already happening. It is interesting to note that the share prices of all the portfolio holdings mentioned above as examples of businesses that are buying back shares are, at the time of writing, up by more than 25% year-to-date5.
Company management teams aren’t the only marginal buyers of UK equities, however. Overseas corporates are also responding to the undervaluation of UK plc by stepping in and bidding for domestic companies at a record rate. Although this is immediately positive for the shareholders of the companies that are being acquired, it does raise broader longer-term issues about the health of the UK stock market and the broader financial ecosystem.
Hence, we are seeing more public discussions around structural reforms which could revitalise prospects for the UK equity market. These have concerned potential changes to listing rules to create a more attractive environment to be a UK plc. There is also focus on whether more UK pension fund capital could be allocated to UK assets. If implemented effectively both of these policy initiatives could also be positive for UK equities.
Some of this improving narrative may be behind the moderation of UK equity outflows and the improved performance of UK equities over the last 12 months. We are hopeful that this will continue and would point to the increasing prevalence of share buybacks, the continued interest of overseas corporates and the prospect of more supportive policies initiatives as reasons to be increasingly positive about the outlook.
Sue Noffke
Head of UK Equities, Schroders
Portfolio Manager, Schroder Income Growth Fund plc
1 It is important to note that, as active and engaged shareholders, we would not be supportive of a share buyback unless the company in question possessed this financial strength. Without it, or in situations where a company is contemplating borrowing money to retire equity, a buyback can introduce more financial risk to the investment case, which generally speaking is not a good idea. Typically, a buyback should only be considered as a use for surplus cash flow (the clue is in the name).
2 Source: Bloomberg from 1 January 2000 to 31 December 2023. Past performance is not a guide to future performance and may not be repeated.
3 Source: Company records, as at 1 August 2024.
4 Source: Company records / Bloomberg to 30 September 2024. Past performance is not a guide to future performance and may not be repeated.
5 Source: Bloomberg to 16 October 2024 in capital return terms. Past performance is not a guide to future performance and may not be repeated.
Important information
This communication is marketing material. The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy.
The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.
Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell.
The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.
Issued by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.
