The Hindu Business Line : Read the ‘buyback’ signal right

In choppy market conditions such as the current one, ‘buyback’ seems to be the buzz word for companies all over the world. Eager to infuse confidence in investors in turbulent markets, companies such as Reliance Infrastructure, DLF, Great Offshore and a host of others have come up with buyback announcements, aggregating to Rs 3,000 crores.

Well, the scene is no different in the US either, with some of the big companies such as Microsoft, Hewlett-Packard and Nike offering to buy back their shares from the public.

Regulations

The Securities Exchange Board of India (SEBI) permits companies to buy back their shares either by giving a tender offer or by purchasing shares from the open market.

While companies, until the early part of this decade, followed the tender offer method (where a company repurchases its shares at a specific price), today, they prefer open market buyback schemes.

In an open market offer, companies purchase their shares by announcing the maximum buyback price; the actual price at which shares are bought back may vary from this announced price.

As per the Companies Act , the maximum amount of shares that can be bought back should not exceed 25 per cent of total paid-up capital in that financial year.

Further, companies are prohibited from issuing the same class of shares for a period of 24 months from the time of buyback.

Rationale

A company may decide to buy back its shares, if it is left with large cash surplus. Companies seeing low valuations also go in for a buyback to signal that their shares are undervalued and to boost their valuation ratios.

Key ratios such as Earnings Per Share (EPS) and Return on Net Worth look better, post buyback, because they are based on the number of outstanding shares.

So, even if the earnings don’t change, the performance will still appear attractive. Investors should note that in such cases, EPS improves without improvement in profits or sales.

Buybacks may also help offset large employee stock option programmes that tend to dilute earnings.

The threat of a hostile takeover is yet another reason that compels companies to buy back shares.

By mopping up outstanding shares from the open market, the company makes it more difficult for another to take control.

The real picture

The Sensex, which was hovering at around 21,000 points in January, has lost about 33 per cent to sink to 13,000 levels.

The broad-based selling that has accompanied this meltdown has trimmed valuations for many stocks. About 20 companies from various sectors have used this occasion to announce buybacks. Reliance Infrastructure, Sasken Communication, Madras Cements, Gujarat Flurochemicals, SRF, Patni Computers and TTK Healthcare are among them.

Though the motive of a buyback typically is to provide support to stock prices the actual price performance of companies in recent buyback offers suggests that the announcement does not deliver any sustained boost to valuation.

Reliance Infrastructure, for example, was trading at Rs 1,459 per share when its Board announced the buyback plan. Now its shares have dropped about 40 per cent and are currently trading at Rs 863.

Similarly, Madras Cements and Sasken Communications have dropped 37 per cent and 29 per cent, respectively, after buyback announcements. While the Sensex has also slipped by 33 per cent, the performance of these stocks is still disappointing.

Hence to get the true picture, market conditions and company-specific fundamentals appear to be far more important for an investor looking to select stocks.

The accompanying table is a performance indicator of how some companies have reacted to the buyback. This suggests that a buyback cannot be treated as a buy signal.

It indicates that with the exception of Mastek, none of the stocks, where buyback announcements were made, have escaped the recent corrections.

Mastek, whose shares were trading around Rs 296 at the time of the announcement, is now at Rs 329 per share, earning a 10 per cent return since then. Companies in the capital goods, power, infrastructure and IT sectors, have made buyback announcements as stock prices have been battered by factors such as high interest rates and the broader slowdown.

Possible strategies

How then should an investor deal with the stock of a company announcing a buyback?

For one, it is definitely not prudent to enter these stocks solely based on a buyback announcement. The steeply falling prices do not encourage trading gains.

An investor who has already lost money on these shares would find it a good exit option to cut his losses. The call on exit has to be based on the fundamentals of the company.

Participating in a buyback is tantamount to exiting the stock in the open market.

Hence, it should be made on the basis of the company’s financials and valuation ratios.

Do remember that holding the shares in the long term will not disappoint you, provided the fundamentals of the company you invest in are strong and its financials are promising. It will give you the benefit of reduction in number of shares and an improved EPS.

Choosing to go with a buyback depends upon the investment patterns, willingness to take a chance and the quantum of losses that an investor can sustain.