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Questor: why shareholders should cheer when Lloyds’ share price refuses to rise
Questor Income Portfolio: it sounds like heresy from a share-tipping column but income investors should hope that the bank’s share price remains depressed
Since we added Lloyds Banking Group shares to Questor’s Income Portfolio in December 2016 the annual dividend has risen by about 5pc while the share price has gone nowhere. But far from lamenting the failure of the shares to rise, we should positively welcome it because it will in time make our readers better off. How can this be so?
The full-year dividend for 2017, our first full year of ownership, was 3.05p a share. In its full-year results for 2018, published on Wednesday, the bank said it would pay a total divi of 3.21p, a rise of 5.2pc. The shares cost 62p when we added them to the portfolio and they closed yesterday at 60.33p for a loss of 2.7pc.
What is more, on almost every measure the bank’s financial strength and profitability are improving (profits rose by 13pc, costs as a proportion of income fell to 49.3pc, the huge PPI redress payments have slowed to a trickle and the key ratio of capital to loans is a healthy 13.9pc).
But why should we welcome the refusal of the share price to rise in step with improving profits?
The answer lies in the “share buyback” programme that has been a feature of the bank’s strategy recently and which this week Lloyds said it planned to continue and indeed expand.
Share buybacks often arouse confusion or annoyance among private investors, who tend to say they would prefer a special dividend if a company finds itself with surplus cash that it wants to hand back to shareholders.
But Questor believes that, in the right circumstances and carried out in the right way, buybacks can be beneficial to all shareholders, including those who, like the readers of this column, own the shares for the dividends.
The logic of share buybacks is that they reduce the number of shares in issue, which means that more of the profits made are attributable to each remaining share. In other words, all else being equal, they increase the “earnings per share” – and that in turn means more scope for an increase in the dividend per share, which is what income investors want.
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But what is crucial is the price the company pays when it buys back its own shares (which it does on the market just like anyone else who wants to acquire stock). If the share price is depressed, the money that the company has set aside for share repurchases simply buys more shares, increasing the effect of concentrating the profits on a smaller number of shares in issue.
If the share price is high, the pot of money allocated to the buyback programme buys fewer shares and the effect is more muted.
Clearly then there is a share price threshold above which share buybacks should be considered a poor use of surplus funds. This is the approach adopted, to Questor’s approval, by Next, as we discussed here in September last year. We would like to see Lloyds do the same.
The bank said this week that it would spend £1.75bn on this year’s share buyback programme. At the current share price this would reduce the number of shares in existence by about 4pc. All else being equal, earnings per share should rise by about the same percentage and thereby give scope for a similar increase in the dividend even if profits were to be static.
This effect is permanent: if nothing else changed, the dividend could be 4pc higher every year as a result of the buyback.
However, the potential rise in future earnings per share and dividends will be less if Lloyds’ share price has risen substantially by the time it actually buys back its shares (in practice it will spread out the repurchases over the course of the year to avoid large transactions disrupting the market).
This is why, in the current circumstances, we should be happy if Lloyds’ share price remains at its current level for a while. In short, the lower the share price, the more prudent the use of the bank’s money – your money – to buy back shares.
Of course we can say this only because our portfolio is focused on income and intended for investors who may never want to sell their shares. Those who bought in the hope of capital growth will have a very different view.
- Questor archive: telegraph.co.uk/questor
Another way to look at share buybacks by ordinary businesses such as Lloyds is to compare them with the widespread use of the practice by investment trusts, sometime referred to in Questor’s “investment trust bargains” column on Thursdays.
Investment trusts regularly buy back their own shares in the market when they are trading at a discount. Irrespective of whether it succeeds in narrowing the discount, the repurchase has the effect of boosting the assets per share of the remaining shareholders, because the trust did not have to spend the full value represented by each share when it bought them back.
In effect, any share buyback at a depressed share price represents the purchase of assets cheaply - the kind of capital allocation decision that any shareholder should applaud. The difference with an investment trust, of course, is that there is an objective measure of when the shares are undervalued: the existence of a discount to net asset value.
Questor says: hold
Ticker: LLOY
Share price at close: 60.33p