The Bruce Column — Brickbats and buybacks

  • Robert Bruce Image

17 Aug 2011

It is almost twenty years since Terry Smith first hit the business headlines.

He was head of UK company research at what was then, UBS Phillips & Drew. He took an interest in financial reporting and accounting matters, unusual for the time, particularly as it was the heyday of what was referred to, carefully and with tact, as "creative accounting". What he did was identify what he felt were the main creative accounting techniques at some of the biggest companies of the day and place a blob against each of the techniques they used. This dramatised the issue. The more blobs a company had the more they should be treated with suspicion by investors. His system became famous. He wrote a book about it, ("Accounting for Growth: Stripping the Camouflage from Company Accounts"), for Random House. Then some of the companies concerned brought pressure to bear on him to stop its publication. He pointed out that it was now the publisher's book, not his. The book became a bestseller on the back of the publicity. Smith was escorted from the UBS building and set about building a new career, first with brokers Collins Stewart and now as Chief Executive of brokers Tullet Prebon and investment company Fundsmith.

These days he is a happy man in business terms and a happier man in terms of financial reporting. The near-twenty years since his book came out roughly coincided with Sir David Tweedie's efforts to sort out the problems, first at the UK Accounting Standards Board and, second, at the International Accounting Standards Board. 'Tweedie & Co did a good job', he says. 'They did most of the work needed to change accounting'. So the old creative accounting techniques have mostly been hit on the head.

But he does have one complaint about current practice. And that is the practice of share buybacks. He puts his case succinctly. 'The problem is that when a company repurchases shares they disappear from the balance sheet', he says, 'and this can be used to distort measures of company performance. Simply by executing a share buyback rather than paying out dividends companies can inflate their earnings per share figure and are almost universally seen to have created value for shareholders when mostly they clearly have not'.

He invents an example where two identical companies, (same profits, tax rate, number of shares in issue, shareholders fund and debt), have identical earnings per share figures. They both decide to return the same amount to shareholders. One does a share buyback. The other pays a special dividend. The result is startling. The return on equity will be the same for both companies but the earnings per share figure will be higher at the company which goes the buyback route. And, as Smith argues: "If you review the comments of management, analysts and the press you will find that this will almost universally mean that the buyback company will be seen as having created more value".

Smith suggests this is not really the case. 'Can that really be so if their return on equity figures remain identical and so does the amount of equity capital employed and they have both returned the same amount to shareholders?'

As a result he questions the current reliance on earnings per share as a relevant benchmark. 'This raises the whole subject of whether growth in earnings per share should be the primary or even the sole measure of value creation, or is even valuable at all for this purpose', he says, 'a myth which we thought had been exorcised many years ago but which seems to keep coming back to life like a character in a vampire movie'.

And there is the question of why so many companies opt for share buybacks as a means of returning capital to shareholders. Smith thinks this is obvious. 'The answer, of course, lies in how company performance is judged and management incentives set', he says. 'Earnings per share is still the single most frequently used measure of company performance and metric used to set performance targets for equity incentive plans'.

So what should be done? First: accounting reform. 'We want an accounting change so that the shares remain as part of shareholders' funds and as an equity-accounted asset on the balance sheet in calculating returns. At the moment share repurchases disappear from the balance sheet', he says. 'We need to bring them back on'.

And the second change is one of company attitudes. 'Investors should say that they require the company to give them at least as much information on share buybacks as they would if they were buying shares in another company'.

Terry Smith is chief executive of the investor, Fundsmith, and so it has written to a wide variety of companies to ask them to explain their attitudes to share buybacks. 'We have had a shrug of the shoulders from some', says Smith, 'and some have come back with very good responses. But no one has come back to say: "No, You are wrong"'.

And, as the events of twenty years ago showed, Smith has a good record of getting his views heard.

Robert Bruce August 2011

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