Of Buybacks and IPOs


Director, Banyan Tree Advisors

December 20, 2011

It’s the season for buybacks, with several companies choosing to return cash to shareholders rather than invest it in other avenues. What does this mean for investors?

THE INVESTING public is today as familiar with the terms ‘buyback’ and ‘public issue’ as it is with ‘rolling settlement’ and ‘margins’. Around 25 companies have recently completed buybacks, and at least a dozen more are in the process of
doing so. Public issues have been around for umpteen years now (they are pretty unpopular these days though, thanks to the enormous amounts of money lost by small investors), but buybacks are a relatively new concept.

What are buybacks? A buyback is essentially the reverse of a public issue. While in the latter, a company raises money from the public to fund expansion or diversification, in the former it returns cash to its investors. So, money actually
flows in the reverse direction — from the company to shareholders.

This cash for funding buybacks comes from various sources. In some cases, it’s from the sale of assets (like Madura Coats and Raymond), while in others it’s from a mountain of cash collected over the years (Bajaj Auto). In the context of
buybacks, mountains of cash doesn’t mean the absolute amount of cash with a company; rather, it is a company’s cash holding as a proportion of its net worth.

Hence, even a company of a smaller size (Crisil, to name one) could be said to be sitting on a mountain of cash.

Why buybacks? Historically, managements have considered themselves to be the rightful guardians of the cash their company generates – they decide where the cash is to be invested. Unfortunately, the track record of Indian managements in capital allocation is rather dismal. If a company has few investment opportunities other than debt instruments, buybacks are one of the best ways of utilising free cash in its books. After all, if a company earns 16 per cent or more in its core business, it doesn’t make much sense for it to invest in instruments earning 11 per cent or less.

The fact that a company is returning cash to its shareholders does imply a dearth of investment opportunities within the company. The business the company is in could be facing tough times, which justifies it not committing fresh investments at this point in time. Further, the company may not wish to diversify into unrelated areas, where it doesn’t have sufficient expertise. Also, if the company is a high free cash flow generator, it is perhaps able to fund its growth quite well from
internal accruals.

By returning cash to investors, the company can improve its return on capital employed (RoCE). Also, many companies run quite well on their existing operations, and sucking out cash actually helps maintain financial discipline. It’s certainly better than investing in projects of dubious profitability just in order to become a larger company.

Returning cash to shareholders is a far better strategy than that adopted by some companies who went ahead and bought units of equity mutual funds in February and March 2001, when the market was at its peak. With cash in their hands,
investors can then utilise it in a manner that suits them best — in debt securities or in shares of other companies that are growing faster.

IPOs versus buybacks. Companies issue shares when they think they are overvalued. In the early-nineties, many of us marked our entry into the stock market through shares purchased at low prices through IPOs (initial public offerings) which, when sold in the secondary market, offered sizeable returns.

This was however an aberration, because till 1992, companies were forced to offer their shares at artificially low prices (thank you, O Controller of Capital Issues, the messiah of the small investor). Since then, however, companies have
been given considerable freedom in pricing their public offerings.

But according to Benjamin Graham, an intelligent investor should never invest in a public issue. Now, that’s a drastic statement and worthy of mention only because of the stature of the person making the statement. Graham’s logic is simple – companies mostly issue shares when market conditions are favourable for them to sell (think of the amounts of money raised over fiscal 2000 and 2001, and you’ll know what I mean).

The corollary is that a company will offer to buy back its shares when it considers them undervalued. While this is not always true (for instance, Bajaj Auto bought back its shares at Rs 400; the stock is now at Rs 260, having touched Rs 220
recently), it is reasonable to assume that buybacks do tend to provide a floor to stock valuations.

That’s because a company can buy back its shares only if it has cash on its books or it generates free cash flows. So, the stock price is not determined by some fancy PEG (price earnings to growth) ratio or someone’s imaginary valuation of
the company’s replacement cost, but by hard cash being paid to investors to exit their holdings. Evidence of cash in a company tends to provide a floor to the stock’s valuation. One of the reasons that even tech stocks got a bounce over the
past few months was that some of these stocks dipped to levels below the cash per share in the company.

Shareholder-friendly. In general, a buyback is good for shareholders, as the responsibility for investing the spare cash is passed on to the investor, who can then choose investments in tune with his risk appetite. Also, given the pathetic
track record of most Indian managements in the deployment of cash (often in loss-making megalomaniacal projects), shareholders are much better off with cash in their pockets.

Investors stand to benefit that much more if the buyback is below the book value per share of the company. This is akin to a company issuing shares at a premium. Buyback below book value will shrink a company’s absolute net worth, and therefore enhance return on equity, as profits (from other income) will not fall as much. The following calculation shows that a buyback would also boost a company’s earnings per share and book value per share, further enhancing value.

Just as an IPO bubble is symptomatic of an overheated bull market, large buybacks suggest that the overall price level of stocks is quite low – in fact, low enough for companies to pay cash to buy back their shares. After the severe downswing in stock prices, it hardly bears repeating that stock prices are low, but when insiders — and no one is more ‘insider’ than the company management — feel that prices are low, maybe we should be buying.