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Reflect, Retain, Return

by | Jul 26, 2023

When there is “excess cash” on a balance sheet, management is left to ponder whether to return that cash to shareholders and if so in what form? While we appreciate that opinions can vary on this matter given individual preferences like tax status, our view always reflects what is in the best interest of the company and the company’s shareholders over the long term.

At Sprucegrove, we have always coveted strong balance sheets as they enable our portfolio holdings to continuously reinvest back into their businesses and better position them to navigate changing economic environments and/or unforeseen events. Simply look at today’s economic backdrop: inflation has returned, central banks are rapidly raising rates and many of the world’s economies are slowing. So as management teams begin this debate, we encourage them to first step back and reflect on the resiliency of their balance sheets as the prudent decision may be to simply retain the cash.

Given today’s economic backdrop, we take tremendous comfort knowing that in aggregate our holdings are underpinned by strong balance sheets with 30% of the holdings in a net cash position.

June 30, 2023 Average
NDE		 % of Holdings with
Net Cash		 % of Holdings with
NDE b/w 0-25%		 % of Holdings with
NDE >25%
International 23%   30% 31% 39%

Note: Net Debt to Equity analysis of portfolio holdings excludes cash and financials. The Net Cash and Net Debt to Equity of underlying portfolio holdings does not alter or influence portfolio liquidity and is for the period indicated.

Only when the balance sheet is deemed appropriately strong, should the debate between buybacks and dividends begin.  While the penchant for buying back shares used to be a U.S. phenomenon, in recent years it has clearly gained traction in overseas markets like the U.K. (Anglo American, IMI, Smiths Group, Shell, Spectris and Travis Perkins) and Switzerland (Holcim, Novartis, Richemont and Roche Holding). Even in conservative countries like Germany (BASF, BMW, Fuchs Petrolub and Henkel) and Japan (AIN Holdings and Seria), management teams are returning to share buybacks after a long hiatus or embarking on their first noteworthy programs.

We do not favor buybacks at Sprucegrove but we will tolerate them if companies employ them opportunistically; specifically, when they believe their shares are undervalued. Too often, companies have become serial acquirers of their shares, and are valuation agnostic.  In these instances, our preference would be an increase to their regular dividend or simply to issue a special one.

For a recent example of this disappointing behavior within the portfolio, we would point to U.K. spirits company Diageo, which we exited last year. The business was performing well, and valuation was high given their positioning to take advantage of trends like premiumization and the boom in Tequila that accelerated during the pandemic. Unfortunately, at the same time, management decided to reinvigorate their buyback program and even use debt to accelerate it. This was not the first time and this ill-advised capital return factored into our decision to exit the position.

In our opinion, a more prudent course would have been to take a cue from U.K. homebuilder Berkeley Group or fast fashion retailer Inditex, two other portfolio holdings who regularly issue special dividends to shareholders. A special dividend from Diageo would have recognized the unique time that was the pandemic, helped guard against management’s natural exuberance and allowed all shareholders an opportunity to reinvest those proceeds into more attractive alternatives.

While today the trend in the market is clearly in favour of share buybacks, Sprucegrove remains steadfast in our guidance to encourage management teams to reflect longer term on their individual circumstances rather than simply follow the herd.

[1] Source:  Sprucegrove, MSCI, FactSet

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