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Why share buybacks are not always a good thing...

Jun 3, 2015

In this issue:
» Did real estate as an investment make sense?
» How will the monsoons pan out?
» India Inc. not too enthused about the rate cut
» ...and more!


00:00
If you do a Google search on the meaning of the word 'fad', this is what you get, "An intense and widely shared enthusiasm for something, especially one that is short-lived; a craze."

Fads are fine in fashion where a typical person would want to wear something that is in vogue and not too out-dated. In the field of investing, fads are dangerous. Especially as the definition points out they are a craze and short-lived.

History has ample evidences of fads or themes that have caught the fancy of investors. Not just in India but in the global markets as well. Most of these have ended badly.

And one such fad doing the rounds especially in the US is share buybacks. Buybacks typically are one of the indicators of how companies are choosing to deploy cash. Companies having excess cash can utilize it in various ways (1) dividends to shareholders (2) share buybacks (3) investing it back into the business to pursue growth opportunities and (4) mergers or acquisitions or buying technology or brands.

In the US, loose monetary policies have bolstered the cash reserves of many companies. Indeed, quite a few have been capitalizing on the near zero interest rate scenario and going on a borrowing binge. But given that the US economy continues to remain weak, a lot of these companies are not really spending it on capex or R&D that can set the stage for the next round of growth. Instead, this cash is being used towards buying back shares. So while in effect, the EPS is increasing because of the buyback, in some sense this is illusionary because it is not backed by growth. And by not investing in the business, in some sense, these companies are hampering their own growth prospects in the future as well.

As reported in an article on Bloomberg, companies in the S&P 500 last year spent a combined US$ 890 bn on share buybacks and dividends, compared with US$ 702 bn on capital investment.

And this is where we would like to point out that buybacks are a tricky thing. Buybacks make sense if the company believes that its shares are undervalued in relation to its earnings prospects. Thus, the logic that you should buy shares of companies if valuations are reasonable applies to buybacks as well. This is not what one is seeing in the US. There, the excess liquidity has driven up the stock prices of many US companies to the point that valuations have become unreasonable. Thus, the companies are buying back their own shares at prices that are expensive. So while this may on the surface buoy investor sentiments because of the rise in EPS, what you need to also consider is that it ultimately reduces cash earnings to that extent. Secondly, borrowing money to fund buybacks is also not ultimately in the shareholders' interest in the long run.

In India, we are thankfully not seeing this fad. But we would like to point out that investors should not automatically assume that buybacks are always a good thing. The reason behind this move should be closely looked at. At the end of the day, an increase in earnings should be more a function of the inherent robustness of the company's business. Because that is what will help it grow at a healthy pace.

Do you agree that share buyback is the best form of utilizing excess cash with companies? Let us know your comments or share your views in the Equitymaster Club.

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02:21
 Chart of the day
Our long time readers would be well aware of our views on real estate as an asset class. Not only is it a large ticket size investment, but is also way less liquid and riskier in some sense. The influence of black money and cash transactions in the sector makes it all the more dirty. Not to mention the relatively unfriendly taxes that this asset class attracts. Further, investors' ROI can go for a toss if the properties are not delivered on time - essentially it would be difficult for buyer to be 'in the know' on when the possession will come into his hands as it is pretty much dependent on the builder and his credibility - the latter which can go for a toss overnight in certain cases.

Did real estate as an investment make sense?

Today's chart of the day displays the average per annum returns as indicated by the city wise housing price index (NHB Residex) . The returns are calculated from the start of 2007 till September last year. While there have been certain cities that have done well, the same cannot be said about returns across. The average combined returns for all of the above mentioned cities came in at 8.7% per annum. While returns in Chennai and Mumbai markets have been good, housing investments in cities such as Bangalore and Hyderabad have been poor.

We reiterate our view that while real estate investment may make sense for the purpose of diversification, it is not a route most can afford. And taking on loan to fund the same would be a big no-no as per us. Earlier this year, at the Equitymaster conference 2015, real estate investor, developer & Co-Founder of Primary Advisors, Ashwin Ramesh had provided some key insights on investing in this asset class. He was of the view that for people looking to invest in properties, it would be essential for them to be close to the property so as to manage it better. This is an important piece of advice we believe, which should not be ignored.

Today's edition of the Mint carried out an article which used the above chart for making a case for not investing in real estate. The author was of the view that to make a killing in real estate, one would need to time the market and the location very well. Secondly, the average annual return on real estate over the long term is less than the average returns on equities. The author further added that rental yields in the range of 2-3% in key metros only go on to indicate how overbought the asset class may be; instead one would be better of earning more post tax returns from deposits.

We couldn't agree more!

03:22
The front pages of almost all the business dailies carry write ups around the dull monsoon period that is expected this year. Turns out that the Indian Meteorological Department (IMD) has revised its projection for the monsoons this year for the worse, stating that the probability of weak monsoons has risen to 93% from 68% earlier. The chart below indicates the prior year projections versus the actual rainfall and the projections made for the current year by the two institutions - IMD and private weather forecaster Skymet. As you can see, the jury is mixed on how the monsoons are likely to pan out this year between the two forecasters.

How will the monsoons pan out?
Data source: Business Standard, Department of Agriculture, IMD and Skymet; LPA - long period average

It, however, does seem that the markets are going with the more pessimistic view (that of IMD) considering how they have fallen over the past few days. There is no doubt that monsoons play an integral part in the Indian economy. However, basing investment decisions on such unpredictable outlooks would only lead to more errors in the process. Long term investors would do well to take advantage of market follies in such instances is what we believe.

04:11
As the markets, the finance minister and India Inc clamoured for a rate cut, the RBI yesterday obliged and cut rates by 0.25%. But India Inc atleast does not seem to be cheering. And what it is not happy about is the quantum of the cut, since it was expecting more. The major argument seems to be that since inflation has been coming down and the Make in India campaign has to receive a boost, it was crucial for the RBI to announce a higher rate cut.

The problem is that it is not as simple as it seems. True that the manufacturing sector in India needs a revival. But relying solely on rate cuts was not really going to do the trick. Further, as mentioned above, the Met department has lowered its monsoons forecast. This means that another season of deficient monsoons could put pressure on food production. And this could lead to higher food prices thereby raising the prospect of higher inflation. In such a scenario, given that the RBI's focus has always been to keep inflation under check, a cautious rate cut makes sense.

04:46
Indian markets languished in the red for most part of today's trading session on the back of persistent selling pressure across index heavyweights. At the time of writing, the Sensex was trading lower by about 378 points. Losses were largely seen in FMCG, healthcare and oil & gas stocks. Both the midcap and smallcap indices were not spared either and were trading lower by around 2% at the time of writing.

04:55
 Today's investing mantra
"You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Devanshu Sampat (Research Analyst).

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Equitymaster requests your view! Post a comment on "Why share buybacks are not always a good thing...". Click here!

1 Responses to "Why share buybacks are not always a good thing..."

Kamal

Jun 4, 2015

It may be good for the company .But it is not good for the retail long term investors who hold a portfolio of blue chip companies.Is SEBI listening?

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Equitymaster requests your view! Post a comment on "Why share buybacks are not always a good thing...". Click here!
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