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Share Buybacks - Are They Really Creating Wealth?

| 4/19/2012 9:00 PM Thursday

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.

 

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