Every Tuesday afternoon we publish a collection of topics and give our expert opinion about the Equity Markets.

For most businesses, a Chief Executive Officer (CEO) is the highest-ranking employee. Everyone knows that a CEO leads the company, but what do they actually do day-to-day? The role can be diverse and depends on the company but effectively the CEO is the ultimate decision maker and, arguably, the most important decision they make is around capital allocation. Unfortunately, most listed CEOs are deficient in this skillset highlighted by the common mistake of buying high and selling low. ABSI this week will analyse the common trap of share buybacks that are increasingly becoming an issue for ASX CEOs. 

It is important to appreciate that a company CEO is the ultimate authority on how to spend cash/profits with the aim of maximising return on investment (ROI). Usually, the best use of cash is reinvestment into the company itself to spur further growth but for mature companies, there can be a lack of reinvestment options so the next best capital allocation decision is to return the capital to shareholders in the form of dividends. Usually, the two subprime actions are to make are acquisitions and share buybacks. That isn’t to say that all acquisitions and buybacks are bad for shareholders but most CEOs have a bad track record of creating value from these capital allocations. 

For the uninitiated, just as companies can issue shares to raise cash, they can also use excess cash to buy back shares to reduce the share count. When executed strategically, buybacks can enhance shareholder value by signalling confidence in the company’s future and boosting per-share performance in a tax-efficient way. However, execution is always easier said than done; quite often CEOs recommend buybacks at prices well above intrinsic value during bull markets. Unfortunately, history is flooded with numerous examples and one of the best examples is currently unfolding.

In the market crash of the COVID-19 pandemic, many listed companies raised emergency capital by issuing new equity to investors at severely depressed values. CEOs saw this as a prudent measure in order to strengthen balance sheets during a period of novel uncertainty. Fortunately, the worst fears weren’t realised and the market quickly recovered. Today business, as a whole, has benefited from a small post-pandemic boom and is sitting on excess capital just burning a hole in the pocket. Despite stocks at all-time record highs, many ASX CEOs are choosing to initiate buybacks as a capital allocation decision for this excess capital, falling for the classic sell low, buy high pitfall.

Source: Google Finance

Take hearing-aid producer Cochlear (ASX:COH) as an example. On March 26 2020, COH announced an A$880m placement to institutional investors with a subsequent A$50m share purchase plan (SPP) to existing investors. The deal was priced at A$140/share which was a steep discount to the A$216/share the stock was trading at on March 13. In its December half-year report, COH recorded A$157.7m in net profit, generated ~A$130m in free cash flow, and ended the period with A$89.4m cash at the bank and debt of A$233.7m.

I understand this is Monday morning quarterbacking, but the raise doesn't seem completely necessary and even with hindsight, the quantum was far too much. COH issued over 6.6 million new shares for the capital raise, diluting existing shareholders ~11.4% and taking the total ordinary shares outstanding to 65,687,402. Fast forward to today, and COH has been buying back shares at much higher prices than the pandemic issue. In FY24, 179,206 shares were bought back between prices of A$221.96 and A$279.43. Moreover, the buybacks continue in FY25 with 54,500 bought back so far at prices between A$275.61 and A$300.93, a 114% premium to the pandemic issue. Today there are still approx. 65.5m COH shares on issue and management continues to buy them back indiscriminately. 

Noteworthy, COH isn’t alone in these poor capital allocation decisions. Other ASX 200 companies currently buying stock include, but are not limited to, Qantas, Commonwealth Bank, AMP, and IAG. Like many others, Qantas ended up raising ~A$1.9 billion in June 2020 at A$3.65/share and today are buying back these shares at record highs of almost A$9/share. Again this is demonstrating poor capital allocation decisions at a time when the brand is under stress due to a swath of negative PR. One would think a better capital allocation decision would be an investment into updating the rapidly ageing fleet, improving customer service channels, or putting it aside for the upcoming compensation bill to be paid to illegally sacked workers. 

Nobody can blame Qantas for raising capital at the height of the pandemic but what’s interesting was that they were still conducting a share buyback up until 10th March 2020. Surely an airline like Qantas, which has encountered travel disruptive pandemics in the past, would have the foresight to be a bit more fiscally conservative at the smell of a virus that could potentially disrupt travel.

Source: Cochlear 2024 Annual Report

I believe the primary driver of these poor capital allocation decisions by CEOs is how they’re incentivised in their remuneration. Executive compensation is commonly broken down into fixed, short-term incentives, and long-term incentives. Parsing through the COH remuneration structure shows that LTI is awarded based on growth in underlying basic EPS and the relative performance of the share price. Both of these metrics are directly influenced by the amount of shares outstanding. Qantas is similar with more emphasis on share price performance, though they have just added a reputation measure tied to LTI. 

Share buybacks have their purpose and are a great mechanism for CEOs to project confidence in a tax-effective way for shareholders, particularly in regions lacking a franking credit system for dividends. Warren Buffett is a great example of a CEO with the fiscal discipline to only buy back shares when he knows the intrinsic value of the stock is higher than the market value and to have the discipline to hold onto cash. Unfortunately, not every company can have a capital allocator to the calibre of Buffett and while executive compensation continues to be manipulated by share buybacks, you’re going to get shareholder value destruction.

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