Wednesday, September 08, 2010

Share Buybacks Revisited

There was an opinion article in StarBiz today on share buybacks. In its premise, there is one major error. Did you spot it?

StarBiz - "Under normal circumstances, investors should get excited when companies buy back their own shares. In theory, this action implies the management views the best available investment opportunity for the utilisation of excess cash is to invest in its own company rather than buy into some other companies.

This is because when a company buys back its own shares, it will reduce the firm’s outstanding shares and enhance the company’s earnings per share (EPS).

Due to information asymmetry, the management is in the best position to determine that the company is being undervalued at the current price and, thus, it is to the best interest of the shareholders to buy back the company’s shares.

Hence, in general, we can conclude share buybacks usually convey a positive signal that implies the stock of a company is underpriced."

Share buybacks on its own does not reduce the firm's outstanding shares because they are not canceled. The shares outstanding remain the same whether a company buys them back or not. Hence, it is also true that share buybacks does not enhance the company's EPS as well. Considering that 99% of all Malaysian listed company share buybacks do not result in shares cancelation but are kept as Treasury shares - there is NO improvement in EPS.

What should investors’ opinion be of these share buybacks? Should companies make known their intentions?

We need to understand first why there is a stockmarket in the first place? First and foremost, it is there to allow companies to raise cheap funds to fund their growth strategies. Secondly, it is to allow for individuals and other entities to participate in the growth of these companies. Other reasons are secondary in nature. A company raises funds to facilitate corporate strategies, hopefully they will make money, preferably higher than the prevailing interest rate (if not, all funds should put money in the bank and close shop). Successful companies may keep accumulating profits to prepare itself for two general reasons: market down cycles, or in order to take advantage of opportunities when there is a market/industry correction/sell-down.

Companies should only indulge in share buybacks when accumulated funds are in excess for the above two reasons. This is because share buybacks will deplete reserves and may not be easily convertible to cash when there is a downcycle or market correction – the time when funds may be needed for those two purposes. Companies doing share buybacks must and should consider this aspect before embarking on the said exercise. Even then, the company can still decide on other options to do with the excess cash – give back to shareholders in the form of dividends or bonus – especially in a matured industry.

Companies raise cash for investing in growth, if they find no good investing opportunities after a prolonged period and cash flow is healthy, the funds should be returned to shareholders. Companies doing share buybacks are basically saying that that is the best way to spend their excess cash. To arrive at that decision, they must be convinced that their share is undervalued compared to their company's prospects. A company’s share price may not reflect its true potential – who knows the company’s fundamentals better than the people running them.

Then we have to look at why management is doing this – is it to improve share price via reducing the free float; and/or improve the earnings per share (but that only happens when they cancel the shares). If a company has to resort to improving their share price by reducing free float, it is usually not successful – a simple glance at the past 2 years' price performance of most of these companies will tell you that. By reducing free float, it is a futile exercise as the company will have to accumulate a significant amount to prop up the share price – that seems artificial no matter how you look at it as the only group really keen to own the shares is the company themselves.

Of course, share buybacks can successfully engineer higher share prices by massively reducing free float but they will have to meet regulations for minimum free float in the market place. The danger is that share buybacks can be taken advantage as “insider trading” by management as it involves market timing – hence the authorities must be more vigilant when it comes to the timing of share buybacks. If a company buyback the shares and do not cancel them, are they waiting to unload when price is higher? That is tantamount to trading in their own shares or having an investment portfolio. Is that part of the company’s normal course of business? Can this activity account for a substantial amount of profit for the company? How should analysts regard this profit – probably not enthusiastically as it is considered as a “one-off.”

It is safe to say that companies should make their intention known to the public when doing share buybacks – is it for future placements to institutions; to be canceled, if so please state a time frame; not to be canceled, but to be sold back into the market when price is higher; or to be disbursed as bonus. To me, that is vital information and I believe investors will rate the stock accordingly with the new information.

Bottom line, if it is not going to be canceled, share buybacks are not really that big a positive in rating the company. Most times, companies who do share buybacks will not see significant improvements in their share price – investors do not rate a company higher because of that as investors are not buying the stock in the first place for various other reasons, and the freefloat is not really a major reason. Any worthy share buyback has to be canceled for it to be effective.

Companies not doing that, need to ask themselves more questions as to why their share price is not at a level where it should be – are investors not happy with the management’s vision; is the company not communicating its plans effectively; has the company not been able to chart a credible track record; have the financial results for the company been haphazard or inconsistent; is the company too unfocused or too diverse that nobody even wants to follow/research the company; how is the management track record been in treating minority shareholders; have transactions or deals been really fair to all shareholders or been forced down investors’ throat (oops, getting too specific here) – chances are the stock will be rated properly if the above concerns have been addressed. Hence most share buybacks will not be entirely successful as it is fighting against the “enemy” when the “enemy” is really internal not and not external.


lsb said...

beware, when its majority owners selling, direct or through their proxy. said...

I thought--

Treasury shares (shares bought back by company) are not not included when calculating the non diluted eps. So the eps will increase.

And because treasury shares are not subjected to dividend, dividend to shareholders are suppose to increase.

Share buy back allows company to control market price if it is too undervalue, or in the US when market price is attached by short sellers making fake news.

Stocks that has been bought back can be distributed back to shareholders and immediately increasing shareholder value because each shareholders now own more of the company.

Buying back shares is the same as paying back dividends in some sense. Buying back shares is more meaningful if the share is believed to be undervalue. But a shareholder who think the stock is undervalue and receive cash dividend can easily repurchase the stock in the open market.

Different is if company buy back shares, it send out strong signals to the market on what management think about the stock price. And company share buy back has bigger volume to support share price as compared with individual shareholder who try to buy with their cash dividend.

Cancellation of treasury shares are not a wise move for small cap companies that need liquidity. It is wiser to distribute to shareholders.

Big companies are welcome to cancel shares.

Even if treasury shares are not canceled, selling them when the market price is higher will make company money and increasing shareholder value.

Those shares can also be used for acquisition without the need to issue new shares that will dilute shareholders value.

The treasury shares can also be sell in bulk to potential institution investors that need a big volume that buying in market is difficult.

I have full support for share buy backs.

K O said...

Can you please comment on EBWORX?

1) There is an accumulated share buying back driven by the company...

2) The company has cancelled their treasury shares before...

3) Although the company has a healthy cash flow but it doesn't or probably never paid any dividend before...

From: Disappointed EBWORX Shareholder

john said...

ah yap, good points. But you forgot to mention tax. Dividend is taxable whereas cap gain is not, in the malaysian context.

ck said...

My thots open for debate as follows:

I think few of the companies that conducts share buy-back on a frequent basis and yet has poor IR initiative / lack of coverage may use the share buy back as a loop hole for various motives other than the intended one:

1) to prevent all out dilution in major shareholders' interest assuming the said shareholder has placed out a block of his shares to a third party (bearing in mind the treasury shares are not subject to vote)

2) to take advantage of price mismatch. Assuming a coy does a 132D issue at a premium to mkt price (which is rare). The coy can do a buy-back equivalent to the placement and the price differential will be a one off profit to the coy

3) to take out coy's cash without declaring dvd (thus don't allow cash to be shared with MI). Coy cash is misused into buying blocks of major shareholders' shares previously held by their nominees although its a slow and arduous process to complete

Chong Kong Hui said...

May be, yes, major shareholders whom also manage the company may use this way to "goreng" the share price or "cash in" into their pocket.

So, fellow investor, just watch out.

But, not all company do so. At least not Public Bank, do you agree?