Is Buying Own Shares a Waste of Funds?

Last Updated Mar 26, 2010 7:52 AM EDT

Share buy-backs have been rare since the credit crunch struck but BAE Systems is promising a £500m purchase of its own stock. If 2009 was the year of the rights issue, could this be the year when shareholders stop sending their companies cash and receive it back instead?

The worry when directors return money to investors is that they have run out of ideas for spending it. Business certainly seems in no mood to spend: corporate investment is at its lowest levels since records began 40 years ago. Manufacturers cut investment spending last year to 32 per cent below the pre-recession peak and service companies slashed their capital expenditure by more than 28 per cent below 2007's level.

All last year's money raised in rights issues wasn't spent on machine tools or on research, it was used to repay debt and fill the black holes in balance sheets. And with cautious companies cutting dividends they are hoarding cash: the FTSE 100 firms have turned themselves into banks with an estimated £100bn tucked away.

BAE has a relatively modest £400m of net cash in its accounts but it will use all that to buy back shares plus part of its anticipated profits for the current year â€"- even though fines levied after anti-corruption probes helped slash last year's profits from £2.4bn to just £282m.

Before the financial world was turned upside down and when debt was still the height of fashion, buybacks were a favourite way for firms to leverage their balance sheets. Corporations borrowed to purchase their own shares. Some 58 per cent of big companies were at it in 2006, spending £46bn -â€" half of that coming from BP, Shell and Vodafone alone. The following year looked set to break that record until the bubble burst -- though HBoS was still buying in its own shares in December 2007, unaware that it needed every penny of capital it had and would be twice asking its shareholders for more within 12 months.

And that just illustrates how bad companies are at buying their own shares. They may criticise fund managers but their own stock timing is dire. Buying at the top of the market was a waste of company funds: buying cheaply in spring 2009 would have boosted balance sheets much better. Instead, any buybacks last year involved companies purchasing their own bonds to reduce debt rather than trim the equity.

Buybacks through the market are unfair to small shareholders, who learn about them after the event and thus receive none of the returned cash â€"- merely the supposed gain from spreading the company's earnings over a smaller capital base. But the fact that BAE, a business likely to be hit by defence cuts in Britain and abroad, has the confidence to shed capital should encourage others.

In an ideal world companies would be investing in the projects that will earn tomorrow's profits, but giving the money to investors is better than hoarding it and much better than wasting it.

(Pic: Port of San Deigo cc2.0)