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Think Twice Before 'Buying' the Buyback

Feb 21, 2017

In this issue:
» Apurva Seth's Free Special Report!
» TCS Announces India's Biggest Buyback
» Anisa on Creating Wealth
» ...and more!
00:00
Kunal Thanvi, Research analyst

Last year we attended lots of annual general meetings (AGM) across the country. A typical AGM is, at heart, a conversation between a company's shareholders and the management.

I remember an interesting conversation between a shareholder and a promoter of a small-cap company last year. The shareholder, in poetic style, congratulated the company for its good financial performance, saying...

  • I congratulate the company for yet another good year of performance and request the management to consider a special dividend and bonus next year.

Some shareholders have been with the company since the initial public offering (IPO). And in some cases, dividends are their only source of the income. They demand dividends, special dividends, and bonuses.

That said, last year the AGM was divided - i.e. between retail investors asking for dividends and bonuses and analysts asking for 'buybacks' for real price discovery.

This takes me back to the scene from the same AGM last year...

Analyst: Sir, we have good cash on our balance sheet and recently finished our expansion plan. Should we expect a buyback next year?

Management: Yes, we are planning to use the excess cash either to pay dividends or for a buyback.

The retail investors were not happy to hear about the buyback and things got little chaotic. They didn't want to tender their shares back to the company and instead demanded a dividend.

Why the sudden surge in buybacks?

In last year's budget, the finance minister announced a special tax of 10% on dividends above Rs 10 lakhs in addition to a distribution tax of 20%. Many companies went on to declare dividends after the announcement. And those who missed the bus are now taking the share buyback route.

In a buyback, the company purchases its own shares from the stock market. Subsequently, it cancels them or keeps them as treasury shares. The whole buyback process reduces the company's outstanding shares.

A buyback could mean the company has adequate cash to buy its own shares and is willing to reward its shareholders. It could also mean an improvement in financial ratios such as earnings per share, return on assets, and return on equity.

Apart from the above, buybacks make a lot of sense for companies now as they've become more tax efficient in India than dividends.

In 2016-17, buybacks were at a six-year high with forty-one companies announcing a buyback against just sixteen the year before.

So what should long-term investors do?

There's no doubt that tendering a part of your shares in a buyback could be a tempting proposition, especially if the buyback price is higher than the market price.

However, it's important to understand that buybacks reduce the number of outstanding shares. Thus, the shareholders who don't tender their shares end up with a bigger piece of the pie.

Doing nothing during a buyback may not be satisfying to many investors. Receiving cash may seem to be a better option.

But remember, if you really are a long-term investor, buybacks will increase the value of your existing shares. The reduced number of outstanding shares will boost per share earnings as well as ROE. And in the long run, these two measures matter more than anything else.

In all, we believe investors should consider buybacks on a case-by-case basis.

The Indian IT industry is right now going through a dull phase. In addition to the Trump issues, the excess cash on the balance sheet (due to limited growth opportunities) is resulting in falling return ratios.

For major players like TCS and Infosys, cash accounts for 40% of their total balance sheet size. And given the good correction in the valuations over the last one year, a buyback can be one option over dividends. In fact, TCS recently announced a buyback (refer the chart below to see the buyback in the historical perspective).

One of our Hidden Treasure recommendations also recently concluded a successful buyback. We recommended our subscribers not to tender their shares in the buy back, as the long-term prospects of the company are promising.

Buybacks can be seen as a healthy development. However, they'rejust one data point investors should look at. Ultimately, it boils down to management integrity, the company's moat, and the health of the company's balance sheet.

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03:30 Chart of the Day

It's India's biggest buyback. Yesterday, the board of TCS approved a Rs 160 billion buyback of shares, subject to shareholder approval. The number of shares to be bought back, about 56 million, is nearly 3% of the company's equity capital.

The price? Rs 2,850 per share.

The stock price of TCS ended higher by 4% yesterday. But just how significant is this event?

As today's chart shows, TCS has been quite generous with dividends in the past. TCS has paid out almost 45% of its profits between FY11 and FY16. This would be the company's first buyback.

TCS Has Maintained a High Payout

While the company's payout has increased steadily, cash has continued to build up on the balance sheet. This is due to two reasons, very few acquisitions and no buy backs.

The excess cash (over Rs 430 billion) has been a drag on its return on equity which stands at about 33%. This compares poorly with its return on invested capital which is about 60%.

So will this one time bonanza sharply turn around the prospects of the stock? We believe, it's unlikely in the absence of a clear policy about how the management will return cash to shareholders going forward. But at least the first step has been taken.

03:45

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04:10

When we think of people who are wealthy - we often conjure up images of people who have that one 'big' moneymaker - Bill Gates and his Microsoft, for example or Zuckerberg and his Facebook.

But the fact is that most people who have made significant wealth have done it by practicing specific habits, day after day after day, creating the opportunities and opening the doors which led to their ultimate success.

To do this, you need the determination to focus on the process - to make the right choices, and take the right steps towards wealth. This is easier said than done.

Mark Ford learned this when he decided to focus on getting rich.

"Making the statement was easy," he wrote later. "But what really changed me was that I began to apply that goal to everything I did, at work, at home and when I was by myself. I began to ask about everything: 'How can this help me get rich?"

Mark learned how to structure his life and his work to get a little richer every day He figured out who could help him get rich. And who was standing in the way of him being rich. Lean on one. Avoid the other.

Then he simply repeated what he'd done... week after week... month after month. Rethinking the formula as he went. Learning. Developing good habits. Never making the same mistakes. Gaining confidence.

It took him less than 2 years to become a millionaire.

And by the age of 40 (5 years later) he was worth more than $10 million.

He's 66 now and he doesn't like to talk about his net worth. But I can say confidently that it is in the high eight-figure range.

He can share this process with you, but it is you who must choose your focus. If you learn to focus on the process, you'll become wealthier and more successful FASTER than you would've any other way. The 'wealth-building blueprint' is a simple, practical, actionable process that you can start working on right away. If you're ready to focus, keep your eye out for Mark Ford's 'wealth-building blueprint'.

04:45

After opening the day in green, the Indian share markets drifted below the dotted line. Sectoral indices are trading mixed with stocks in the ITsector witnessing maximum selling pressure.

The BSE Sensex is trading down 42 points (down 0.1%) and the NSE Nifty is trading down 12 points (down 0.1%). The BSE Mid Cap index is trading up by 0.4%, while the BSE Small Cap index is trading up by 0.5%.

04:55 Today's Investing Mantra

"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Kunal Thanvi (Research Analyst).

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Equitymaster requests your view! Post a comment on "Think Twice Before 'Buying' the Buyback". Click here!

3 Responses to "Think Twice Before 'Buying' the Buyback"

Nitin Shah

Mar 4, 2017

Is it ok to buy the stocks of cos who have offered to buy back and hold it for long term considering there will be improvement in earning per share post buy back?

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evaman

Feb 21, 2017

What are the tax implications of buy back? Are they (the shares) merely surrendered to the company or sold through the exchange? If the former, will there be no STT on this transaction and hence taxed, even if it has been held for more than an year?
Buy backs imply loosing the share for ever and that is not the desire, but a return of portion of the profit is just fine. If after the buy back, the price does not rise proportion to the buy back price, would that work unfavourably to those who chose to not part with the shares?

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MURALI

Feb 21, 2017

In a case where the shares trade at a lower value than the buyback rate, what if the investor buys new set of shares at the current rate and sell the old tax-free holding to buyback and make some money and still hold same or more of the same stock.

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Equitymaster requests your view! Post a comment on "Think Twice Before 'Buying' the Buyback". Click here!
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