Outlook: Dangers in the buyback craze

Another day, and the promise of another massive share buyback, this time from Rio Tinto (the former RTZ), which is seeking permission to buy back up to 10 per cent of its shares. In Rio Tinto's case, the buyback itself is actually rather unlikely to occur until Advance Corporation Tax is abolished at the end of 1999, for as things stand, 20 per cent of the value of any Rio Tinto buyback would end up with the tax man. All the same, if there's a corporate fashion to be followed, it would surely be a shame for Rio Tinto not at least to look the part.

According to investment banks, 1998 is going to establish a new record for share buybacks and other forms of capital repayment. The reasons are well rehearsed. Companies are being required by their shareholders to "focus" on core capabilities, and the return on capital required of them is much more demanding than it was. As a result, many companies are beginning to throw off excess capital in large quantities. Furthermore, with present very low long term interest rates, the cost of capital can be significantly reduced by swapping equity for debt.

This in turn seems to suit the big investing institutions, who are beginning to view equities as excessively priced. As pension funds mature, their need, in any case, is to move away from "high risk" equities into "low risk" debt and bonds. How wonderfully convenient, then, that this is what the share buyback allows them to do.

Even assuming all this stacks up, and is not just some eloquent piece of theoretical nonsense dreamt up by clever investment bankers in order better to earn their fee, there are clear dangers in the process. All looks fine and dandy in today's benign environment of low inflation and continued growth, but what happens during the next business downturn? Many of these companies will be back, cap in hand, asking for expensive debt to be converted into low yielding equity. C'est la vie.

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