Stock buyback. Why all stock buybacks are not ‘buy’ signals

Here is a simple thought experiment. Let’s assume two companies, Company A and Company B, are identical in all aspects — revenue, profit, margins, future growth prospects and balance sheet line items. Both have excess cash they don’t need and decide to return it to shareholders. Company A chooses to return it in the form of dividends that amount to around 2 per cent of market cap, implying a dividend yield of 2 per cent. Company B decides to return the same amount via a buyback, i.e. it will buy back 2 per cent of its market cap and reduce its share count by 2 per cent. As an investor, would you have a preference between the two companies based on this?

In the Indian context, it does appear that investors would choose company B although there really is no difference between the two. Both are returning money through different means to the shareholders, who rightfully own that money. But a buyback always creates more buzz than dividends. Stocks sometimes move up 5-10 per cent on buyback announcement, but on dividend announcement of equal value, the reaction is inconsequential many a time. Here are four reasons why the buzz around buybacks may be overdone.

1 Short-term prop for prices

SEBI rules mandates that under the tender offer route, 15 per cent of the number of shares a company proposes to buy back shall be reserved for small shareholders (holding less than ₹2 lakh of the company’s shares in value). Since usually the buyback price is fixed at a premium over the prevailing market price and executed over a few months, it brings in arbitrage players who try to capitalise on this SEBI rule.

For example, assume a company has announced a buyback of one per cent of shares at a 10 per cent premium to the stock price at the time of announcement. An arbitrage player who has bought below ₹2 lakh worth of shares could stand to make a 5 per cent return assuming even if only 50 per cent of the shares offered are accepted on proportionate basis under the tender offer. Usually the arbitrage players jump in as soon as markets get a hint of an upcoming board meeting to consider share buyback. Thus, a 10 per cent buyback premium on date of announcement might actually be 15-20 per cent premium from price a few days or weeks prior to the announcement. Hence, this sometimes distorts short-term effect on the share prices.

Take the example of TCS, which has done three buybacks and all via the tender offer route since 2017. In the four months starting with the month when board meet was announced to consider buyback proposal (February 2017, June 2018 and October 2020), the stock was up by around 17, 26 and 24 per cent for buyback of around 2.85, 1.99 and 1.42 per cent of outstanding shares respectively. The upside almost exactly matches price difference between the share price on the date of intimation of board meet to consider buyback and the buyback price.

Under normal conditions — all things remaining constant — a 1-2 per cent buyback should result in negligible impact on fundamental valuation of the stock and its price. It would be hard to imagine similar performance within a four-month time frame if a company had announced dividends amounting to yield of 1.99 and 1.42 per cent respectively. However, subsequent performance indicates the buyback is an inconsistent buy signal — one-year performance of the stock post closure of buyback has been up 40, down 2 and up 25 per cent respectively. On average, an investor in TCS would have made better annualised returns holding in the four months up to completion of buyback versus holding for one-year post buyback.

Another example is Kaveri Seed. When the company announced a buyback of around 4.5 per cent of its outstanding shares in May 2018 at premium of a little over 40 per cent to the price on the day before the announcement, the stock moved up by 35 per cent from the day before buyback announcement to buyback close date. The subsequent one-year return of the stock was a negative 32 per cent.

While companies are well within the rules to make buybacks via tender offers at good premiums — in some cases it might be the best option for them as promoters cannot participate in buybacks done via the stock exchange — investors must differentiate where there are short-term distortions in prices due to tender offer. In some cases, tender offers may be more suited for arbitrage players/traders and not long-term investors.

2 EPS accretive or not?

The significance of buybacks from a long-term investing point of view depends on the fundamental impact that the buyback will have on the company’s future earnings per share.

Any buyback that is going to increase forward EPS (all other things remaining constant) can be viewed positively. The additional aspect to be assessed here is whether the company’s cash/balance sheet position would remain comfortable post returning the cash to shareholders. In US markets where buybacks have reached record levels in current calendar year, companies have the advantage of low interest rates to make buybacks EPS accretive, ie the equity yield (inverse of PE ratio) is higher than cost of borrowing or using one’s own cash to buy the stock. In other words, this implies equity is cheaper than debt (yield and prices move in opposite direction). This may not be the case in the Indian context where in buybacks may not be EPS accretive unless done opportunistically when shares are trading cheap.

The accompanying table analyses buybacks of companies that have done more that one buyback or larger buybacks (percentage of market cap) over the last four years. IT biggies who have done the largest buybacks, Infosys or TCS, have not seen much EPS accretion. Even Accenture, US, has not seen much accretion as buybacks were done when equity yield was low, although EPS growth/net profit growth betters TCS/Infosys.

Compared to this, EPS accretion is significantly higher for other companies in the US, reflecting the lower cost of borrowing or using one’s own cash to do buyback of stocks with higher equity yield. For example, Apple, which has been making buybacks on a consistent basis in the last few years, did most of its buybacks (2017-2019) when the equity yield of the stock was between 7 per cent (PE of 14 times at the start of 2017) and 6 per cent (PE of 17 times till mid 2019). During the same period the average annual yield of 10-year US treasury was in the 2-3 per cent range, the returns Apple could have made on its cash if invested in safe investments. By using idle cash to buy back high yielding shares, Apple has created much higher value for shareholders, with significant growth in EPS versus net profit (see table). From a long-term fundamental valuation view, buybacks add value when EPS accretive.

3 Buyback stocks not always undervalued

The most important aspect of a buyback is that it is a tool in the hands of management and board of a company to indicate to the markets that they believe the shares are undervalued, hence the stock can do with a boost.

For example, after Infosys stock corrected significantly in 2017 upon the unexpected exit of Vishal Sikka, the company announced a buyback of around 5 per cent of its outstanding shares within days, clearly using it as a tool to convey to investors that according to the board and management, the company’s prospects remained good and the stock was undervalued despite the CEO exit. In contrast, the ongoing buyback of Infosys amounting to around 1.5 per cent of its outstanding shares appears to be routine distribution of cash to shareholders. It would not make much difference if this cash was distributed as dividends. Hence, the timing and size of buyback can be used to gauge the signal from management.

Even in cases where the management intends the buyback to be a signal that the stock is undervalued versus long-term fundamentals, do take cognizance of the fact that the managements can be wrong in their assessment or may be using it as a tool to manipulate investor perceptions.

There are many instances of buybacks done at higher prices and the stocks languishing post that. An analysis of the entire list of buybacks announced in FY19 (as per Capitaline database) does not reveal an encouraging picture. FY19 buybacks was taken as a case study here as it had the highest number of buybacks in recent years. Also, it is between two and three years now since the buybacks were announced/completed and this ideally is a long enough period for the fundamentals to have reflected.

With the current euphoria in markets, with most indices, including those reflecting the broader markets, at all-time highs, any management/board indication of stock being undervalued 2-3 years back should have been validated by now. However, the data indicates that of around 70 buybacks in FY19, 75 per cent have underperformed Nifty 50 and 60 per cent have underperformed Nifty 500. Further, 45 per cent have given negative returns. A good example is McLeod Russel which, in FY19, announced a buyback of 4.35 per cent of its outstanding shares at a maximum price of more that 30 per cent premium to the price prevailing at that time. The stock now is down by 90 per cent vs the buyback price and the company recently faced insolvency proceedings.

4 Questionable intent

While SEBI rules warrant that companies ensure at least 50 per cent of shares targeted in a buyback are actually bought back, they can get away by paying a penalty. Recently, SEBI imposed a fine (stayed by SAT) on Cairn India (now merged with Vedanta) for buyback announcement in January 2014 ‘without any intent to fulfil it’.

While there are fines if buyback is not done post completion of regulatory formalities, companies can go scot-free if they announce a buyback that can, in the short term, impact price, but not follow through, for extraneous reasons. It is fashionable for some management/boards to announce a buyback when there is a significant fall in share price on negative news, for e.g., PC Jewellers. When the stock saw significant decline within a few months in 2018, the management quickly announced a buyback which was shelved equally quickly after the bankers declined to give NOC.

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