Share buybacks… and beyond

Over the past 12 months, a remarkable 70% of the Artemis Income Fund has bought back shares. We have previously highlighted this as being both a signal of value (that is, the company believes its shares to be undervalued) and a material transfer of wealth from price-insensitive sellers to patient owners like us. Given the scale and breadth of these buybacks, they have been very positive news for UK equities.

We are frequently asked by board members, company management and co-investors how we feel about share buybacks. Are they still a good use of capital? Should companies continue or extend their buyback programmes? Do they distract from growing the business?

Philosophically, our answer is somewhat equivocal. We think that it depends — on timing, prospective returns on capital and the relative attractiveness of buybacks compared to other options. Where we are unequivocal, however, is the imperative of focussing on the sustainable free cash flow that underpins shareholder returns. Our mantra of ‘free cash flow first, dividends second’ shows not just how we think as investors, but how we expect management teams to behave as stewards of capital.

First look after the fundamentals of the business – that is, protect, sustain and enhance the prospects for durable cash flow growth — and only then will we talk about capital being returned to shareholders. If all those criteria are met, then the ability to buy back the remaining cash flow cheaply is as close to an investment nirvana as one could hope for.

We sometimes stop in disbelief as, without doing anything, our investors are increasing their ownership of companies whose underappreciated fundamentals open up the possibility of wealth transfer from share buybacks as well as wealth creation from growth. No surprise that we want to shout this from the rooftops as this opportunity set is unique to the UK market.

Over recent years, all investment paths have pointed to the US stock market. In some respects, it is the power of this ‘siren call’ that has contributed to the undervaluation of the UK market. Some would say that the US is the ‘home’ of buybacks and this increases the attraction of US assets. But not only is the scale and magnitude of the UK buybacks of a different order, but in the US often the buyback merely mops up the shares issued as part of employee remuneration. Not so in the UK, as stock-based compensation is both rare and relatively modest.

Of additional comfort is the knowledge that unlike private equity, this is not a case of using borrowing to replace equity. Balance sheets and cash generation are strong, and valuations are low, as shown by the near 4% dividend yield on the UK market supplemented by a share buyback yield of around 2%, giving a 6% total return. There may be challenges for the UK economy, but the UK stock market is not the UK economy, rather the world’s most global stock market by revenue with three quarters of revenue derived from overseas.

Wealth transfer in action …

Over the past year, we, along with other shareholders, have managed to increase our ownership of Tesco, the UK’s largest food retailer — and owner of the best consumer data set through Clubcard — by 5%, without investing a single penny. How did this happen? It was thanks to the company’s deployment of its free cash flow to retire shares. Since the buyback started in 2021, more than £6bn has been returned to shareholders – in excess of a quarter of the current market cap of £22bn – with the share count falling 13% and share price up almost 50%.

We first bought shares in Pearson, the world’s leading educational company, in August 2020. Since then, the share count has been reduced by 12%, with another 4% of market cap scheduled to come back in 2025. The shares have returned more than 146% since we bought them in August 2020, versus the NASDAQ’s return of 53%¹. We believe Pearson’s intellectual property and competitive advantages position it to be a beneficiary of technological advancements such as AI and are optimistic the story may only just be getting started.

Wealth creation

The UK market is not all about share buybacks and there may come a time when higher share prices mean that the power of the buyback wanes, so as welcome as this wealth transfer has been, long-term investors also need to see avenues of wealth creation – in other words, looking for Life Beyond Buybacks.

There are two simple building blocks for this. First, a company must offer compelling value to its customers. This will enable it to succeed and underpin the sustainable and durable cash flows that we look for in an investment. And second, we look for thoughtful and prescient allocation of resource and capital which should serve to enhance the business’s competitive positioning and should enable it to grow profitably.

The good news is that the competitive positioning for the type of companies we invest in is the best we have seen in many years. With our six-year plus holding period in stocks, we focus on underappreciated longer-term change, and we see a striking number of structural trends which are making for an enhanced opportunity set for our holdings. There is an emerging cohort of UK-listed businesses that are leveraging technology to create enhanced value from their data and IP. We will elaborate on this and further positive structural trends in future articles. Not only do we own larger stakes in these attractive companies thanks to the share buybacks, but their prospects are better. In short, the Artemis Income Fund offers buybacks… and beyond.