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Beware of overdoing share buybacks

Besides listed companies going private, investors should also beware of share buybacks ("Putting retirement savings in equities? Be aware of the pitfalls" by Mr Chan Yeow Chuan; last Sunday).

Buybacks are not necessarily a bad idea. When firms buy their own stocks in the open market, they return surplus cash to their shareholders, in much the same way as if they were paying out dividends.

If firms cannot find opportunities for profitable investments, handing cash back to investors is the right thing to do. However, it is also a symptom of the weak growth prospects.

Short-term investors and managers could have their own reasons for wanting a buyback.

A buyback can prompt a sudden spike in share prices and a quick buck for short-term investors.

Reducing the number of shares outstanding could also artificially boost a firm's earnings per share.

However, if firms overdo buybacks and neglect long-term investment projects, artificially propped-up share prices will eventually tumble.

Buying their stock at high prices is a bad use of capital.

When a company is spending millions on its own stock, a savvy investor should ask: Why can't it find something better to do with the money?

Every dollar used to buy up stock is a dollar that isn't hiring more employees, ramping up marketing, acquiring a competitor, developing a new product, or otherwise investing to grow the business.

Investors need to pay close attention.

In the long term, they need to ensure that managers' pay schemes are designed in a way that does not create a perverse incentive to repurchase stock.

In the short term, they must give firms a licence to invest.

Francis Cheng

A version of this article appeared in the print edition of The Sunday Times on March 20, 2016, with the headline 'Beware of overdoing share buybacks'. Print Edition | Subscribe