There is this inherent belief that a company announcing a buyback scheme is always a good thing for its investors. It sends a message that the company is doing well and that the management is confident that the good times are here to stay. But a number of factors determine whether or not a buyback will create value for remaining shareholders.
Busting the myth
In many cases, like the Just Dial IPO, a buyback offer seeks to comfort buyers that their investment is somewhat protected. Experienced investors would recall the Reliance Power IPO which came out in the thick of the financial meltdown of 2008. Though Reliance Energy, the majority holder of RPower announced a share buyback amounting to Rs 2,000 crore, it didn’t do much for the stock in the long-term. Five years since, RPower is still down 86 per cent!
Buffett says, “The motivation for a buyback used to be just because companies thought their shares were cheap. Thirty or forty years ago, it was very fertile to invest in companies that were buying back their stock…But that’s being swamped today by companies doing it because it’s in fashion or to prop up the stock…We wouldn’t do it for those reasons,” (Berkshire Annual Meeting 2006).
When should a company go in for a buyback?
Buffett has been very clear on when a company should go in for a buyback. Here in his 1999 Annual Letter is where he first considered a buyback. “There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can buy new businesses or repurchase shares. If a company’s stock is selling well below intrinsic value, repurchases usually make the most sense.”
At what price?
The buyback price determines whether it (the buyback) will eventually create value for remaining shareholders. While logic holds that companies would go in for buybacks only when their stock prices were well below their intrinsic values, that has not always been the case. Says Buffett, “90 per cent of repurchases in the last 5 years were at silly prices and not in the interest of shareholders. Managers did it because everyone else was doing it. It’s interesting how many companies bought at two times current prices that aren’t [buying] now,” (Berkshire Annual Meeting 2009).
This behaviour is not a new phenomenon today. Back in 2000, when Buffett was considering his first buyback he had observed in his Annual Letter, “Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around...It appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more than I do. However, I can’t help but feel that too often today’s repurchases are dictated by management’s desire to “show confidence” or be in fashion rather than by a desire to enhance per-share value.”
Buffett, it consequently follows will not pay over the intrinsic value for re-purchase of Berkshire shares. In the 2011 re-purchase programme, the first in his four decades of operations at Berkshire, he offered up to 110 per cent of book value as the buyback price. He later revised it to 120 per cent. As an indicator of how accurate the market views Buffett’s views of intrinsic value, when he announced the buyback, the market largely acknowledged that Berkshire price was down to attractive levels.
This is eighth of the 11 investing myths we have been talking about. Please click here to know about the other myths.