DSIJ Mindshare

Share Buybacks - Are They Really Creating Wealth?

How would you feel if a stock you have invested in underperforms or declines? Moreover, how would you react if the decline happens at a time when the company is actually conducting a share buyback? Aren’t buybacks supposed ensure better price movement in a stock? I am sure most of you would not even want to think of being in a situation where the stock goes down despite the company having announced or being in the process of buying its stock back, leave alone actually being in one.

The primary objective of investing in stocks where companies have announced a buyback is to generate better returns. However, there is one person who thinks differently, whose views matter a lot when it comes to investing in stocks. He is none other than the legendary Warren Buffet.

In his latest letter to his shareholders, Buffet commented on the irrational reaction of many investors to the change in stock prices during a buyback. He stated, “When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well”. Confused? Buffet explains this in a very simple manner. According to him, one should hope that the stock price languishes during a buyback, as this automatically results in a higher stake.

For example, if a company has one lakh outstanding shares and we hold 5000 shares in the company, our holding in the company work out to be five per cent. As the company carries out a buyback, the number of outstanding shares will reduce. Let’s suppose that the company announces a buyback amounting to Rs 10 lakh at a maximum price of Rs 150. If the stock price is at Rs 150, the company can buy back only 6667 shares, which means that 93333 shares remain outstanding. As a result, our stake of 5000 shares in the company would increase to 5.36 per cent. However, if the stock price declines to Rs 100, the company can buy back 10000 shares, which would mean that 90000 shares remain outstanding. This would take our stake up to 5.56 per cent. Following the primary idea that a company performs well after the buyback and its profitability increases, the higher stake best serves our interest.

So, does it make sense to invest in companies carrying out a buyback? Well, if we go by the primary logic as set forth by Buffet that the earnings of the business will increase at a good clip for a long time to come, it surely makes for a good opportunity, provided that you are investing for a longer period of time. However, if an individual is looking for capital appreciation in the short term, this may not be the right strategy.[PAGE BREAK]

There are certain recent examples which indicate that buybacks hardly help in capital appreciation in the short term. Data collected by us shows that out of the 13 companies that have completed a buyback since January 2011, 11 have witnessed a decline in their stock prices. Rather, by the time the buyback ended, the counters were trading at a good discount to the maximum buyback price fixed by the company. Allied Digital Services (down 79 per cent), Infinite Computer Solutions (down 72 per cent), Manaksia (down 60 per cent) and Bhagyanagar India (down 79 per cent) are all startling examples of this. The scenario is similar in case of those companies where the buyback process is underway. Of the 17 companies that are currently carrying out a buyback, only one scrip is trading above the stipulated maximum buyback price. Jindal Poly Films (down 44 per cent) and Gemini Communications (down 51 per cent) are already trading at a significant discount to the maximum buyback price.

Buyback Closed
Scrip CodeCompany NameMaximum
Buyback
Price (Rs)
Price
(End Of
Buyback Date)
% Change
532875 Allied Digital Services 140 29 -79.11
533154 Infinite Computer Solutions 230 65 -71.65
532932 Manaksia 200 79 -60.35
512296 Bhagyanagar India 35 16 -54.86
509631 HEG 350 201 -42.56
532491 ECE Industries 145 104 -28.07
503806 SRF 380 291 -23.38
500390 Reliance Infrastructure 725 617 -14.85
509635 Hindustan Composites 550 534 -2.92
505537 Zee Entertainment 126 123 -2.46
500696 Hindustan Unilever 280 275 -1.7
590031 De Nora India 105 126 20
532406 Avantel 70 101 44.29

Ongoing Buyback
Scrip CodeCompany NameMaximum
Buyback
Price (Rs)
CMP (April 9, 2012)% Change
532318 Gemini Communication 45 22 -51.11
500227 Jindal Poly Films 350 197 -43.71
520077 Amtek Auto 200 132 -34
532764 GeeCee Ventures 65 46 -29.23
532944 OnMobile Global 85 61 -28.24
532268 Kale Consultants 160 126 -21.25
500325 RIL 870 743 -14.6
533293 Kirloskar Oil Engines 170 146 -14.12
522205 Praj Industries 90 78 -13.33
513446 Monnet Ispat 500 468 -6.4
500380 JK Lakshmi Cement 70 66 -5.71
526775 Valiant Communications 18 17 -5.56
500339 Rain Commodities 41 40 -2.44
507828 Ansal Housing & Constr. 45 44 -2.22
532344 SoftSol India 65 64 -1.54
502219 Borosil Glass Works 850 850 0
500092 CRISIL 1000 1066 6.6
[PAGE BREAK]

Going by this logic of underperformance, these counters seem to be good buying opportunities. However, in reality, the story is quite different. While satisfying the second condition as laid out by Buffet, some of these companies completely defy the first and basic logic, which is of an expected increase in earnings after the buyback. Allied Digital, Manaksia and Bhagyanagar have performed miserably on the financial front, with their earnings having witnessed a decline.

It is still a mystery as to why a company like Allied Digital should have gone ahead with a buyback? Since the March 2011 quarter, its bottomline has declined consistently on a YoY basis, remaining just one fourth of what it was in the preceding four quarters. The topline for the trailing 12 months (TTM) declined to Rs 595.32 crore from Rs 768.75 crore and the bottomline for the same period declined to Rs 23.51 crore from Rs 115.40 crore. The story with Manaksia and Bhagyanagar India is also somewhat similar.

The basic idea is that companies that have strong earnings and those that are expected to continue with the growth momentum should use buybacks to increase shareholder value. But in many instances, the promoters of companies whose earnings are dropping try to use buybacks to signal to the markets that they have a strong conviction in their stock. Thus, rather than creating some real value for existing investors, the companies look at the buyback as a tool to restrict a fall in the share prices, which is a futile effort in weak markets. In 2008, DLF also tried a buyback at a maximum price of Rs 600, signaling that the valuations were cheap. However, since then, the consolidated profitability of the company has only declined and so has the stock price.

Another classic example is that of Reliance Industries, India’s largest company in terms of market cap. After underperforming the broader markets on account of a poor performance, the management opted to buy back the company’s shares. The buyback is still going on, but the scrip has only moved southwards since the process started in February 2012. Here again, the company has satisfied the second condition. However there is a question mark on whether it will satisfy the first condition or not. The financial performance of the company has been muted for the past few quarters. Further, the falling refining margins, the dwindling gas output and a weak demand for petrochemical products raises doubts on RIL’s ability to show reasonable earnings growth going forward.[PAGE BREAK]

Let’s come back to the moot question of whether buybacks really help. Buffet says, “I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated”. He further adds “Continuing shareholders are hurt unless shares are purchased below intrinsic value”. Most of the companies fail to stick to this second part.

However, these are only a few examples where investors have failed to benefit from the buybacks. There have surely been some good buybacks too. HUL has provided positive returns and also witnessed an improvement in its EPS after it bought back shares. Another good example is that of Avantel, which not only posted increased earnings but also provided capital appreciation after a buyback. So, it cannot be said that companies always go in for buybacks only to avoid a fall in the share prices.

The examples given above indicate that a buyback is not advantageous for investors unless the company is financially sound and on a growth path in the long run. Further, a short-term gains opportunity is not possible. To take advantage in the short term, one can opt for a buyback at the price offered by the management. If one wishes to continue holding the counter, one can re-purchase the share later from the open market.

In sum, these factors signify that rather than looking at buybacks as an opportunity for short-term gains, one should look at the long-term gains where the EPS of the company will improve. However, we are of the opinion that the EPS will increase not just with a buyback of shares, but with an improvement in the company’s fundamentals, which then reflected in the increasing earnings. We advise our investors to always look for long-term fundamentals at the time of a buyback.

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