In developed markets, especially in the US, investors are closely watching the news about buyback (buyout of their own shares by issuers). Typically, massive buybacks positively affect the growth of quotations and the dynamics of the indices. Is it really so and what is the role of buybacks in the foreign and Russian stock market – let’s look at this review.
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The concept of Buyback and what it means in the market
Buyback – one of the most common methods of corporate governance and support for market activity. It reduces the share of securities, stocks or ADR / GDR in free float and increases EPS (earnings per share). The mathematics here is simple: in the EPS formula, the S component is reduced, by which the profit is divided. At the same time, the company’s capitalization is not necessarily growing, but the number of shares falling on it is decreasing. Thus, the organizers achieve growth of quotations, keep current and attract new investors. Two main methods of repurchase are used: directly from shareholders and on the open market through the exchange. To encourage shareholders, the buyout price is often put above the market (with a premium).
Not quite accurate, but an exemplary comparison for the buyback is the destruction of unsold items by luxury brands: Swiss watches, clothing and accessories. The goal is to support the cost and prevent sales at reduced prices.
Stock quotes react to the event almost immediately, at the time of the issuer’s public offering of its application. The price moves in the direction declared, even if the market valuation at this moment is lower. The effect is usually temporary, but allows the company to achieve its short-term goals.
The buyback boom originated in the United States in the early 2000s. Then the Securities and Exchange Commission raised the top bar for permitted repurchases from 15% to 25% of daily trading volumes. Some analysts of the American market call this “mass insanity.” This view is due to the fact that buyers with billions of dollars in cash came to the market and acquired their own shares. Quotes, and with them the indices began to grow at this liquidity feed. More than half of their income companies in the United States spend on the repurchase of shares. The buyback volumes in the US market reached a trillion dollars in 2018, as shown in the picture:
Question: why so much liquidity? Here everything is explained simply: the Fed policy since 2009 has been very long focused on zero interest rates . Borrowing money at the minimum interest and maintaining their shares has become an easy and affordable way to improve financial performance. Buyback is often done on borrowed funds, without regard to current prices.
The greatest opportunities for buybacks are oil and gas and mining companies. They accumulate substantial cash reserves, the volume of which exceeds the needs of investing in the development of production. Keeping them in accounts means losing on inflation and exposing yourself to currency risks.
I will list the main motives on which the plans of the bayback are built:
- Return of capital, when increasing the value of the company is more profitable than reinvesting in a business;
- Overcoming the underestimation of the value of shares, through an increase in their domestic price compared with the market;
- Obtaining tax advantages ( dividend tax in most jurisdictions is higher than the tax on the exchange value of securities);
- Protection against unfriendly takeovers, when the “victim”, acquiring his shares, does not allow the buyer to enter the capital and receive a controlling stake;
- Sanitation of excess liquidity after the issue of new shares, which prevents the erosion of capital;
- The use of repurchased securities for the acquisition of other companies;
- The motivation of employees who receive as a reward the securities of their employer;
- Bonuses of top managers who are tied to the growth of the company’s capitalization (in many cases, this motive can be safely put on the 1st place).
What to take into account when analyzing buyback
Assessing the prospects of back-up companies, one should not exaggerate their impact on the dynamics of stock value. There are other equally important factors: revenue, net profit, geopolitics ( sanctions ), the ruble exchange rate, mergers and acquisitions (as well as rumors about them), raw materials quotes, dividend forecasts, etc. And most importantly: how much the company is undervalued or revalued by key factors ( P / E , EPS, etc.). Overbought stocks are difficult to keep from such artificial manipulations as the buyback. Especially if 2–5% of the volume traded on the market is bought out. Therefore, each company should be considered individually and take into account the coefficient of the impact of the repurchase on its financial performance.
Also need to consider:
- the share of shares repurchased (there is a significant difference between 3% and 25%);
- buyback goals, because when canceling (redeeming) the repurchased securities, they leave the market and increase prices, and when transferred to employees, remain as an active asset;
- whether the company’s management buys shares in the market (positive signal);
- What is the participation rate of minority shareholders, that is, how much they will be able to present their securities for consolidation as compared with the holders of large packages, including those affiliated with the issuer.
An interesting moment for an investor occurs when the offer of the issuer is better than the market. By purchasing shares on the eve of the start of the company, you can earn 10-20% per annum for several weeks. True, for this, everything must go according to plan:
- buyback should take place, and preferably in the planned time frame;
- the issuer is obliged to buy the declared volumes (if the demand exceeds the supply, the company may refuse to redeem the entire package);
- consolidation costs should not dramatically increase the company’s debt burden (a buyback on loan funds, especially in Russia, is a serious risk);
- volatility of quotes should not destroy the initial calculations of the investor.
When starting a buyback, companies often carry out a PR campaign designed primarily for minority shareholders. Such a measure should support optimism regarding its shares and raise their value. This should be treated carefully and not take on trust all that the representatives of the issuer say. They are capable of making mistakes regarding the undervaluation of their shares, and they can even deliberately exaggerate it.
Is it worth investing in stocks during the consolidation period
The consequences of the buyback cannot be predicted; they can only be predicted with varying degrees of probability. Often the paper after consolidation sags, that is, the event gives a short-term effect. Of course, the buyback procedure does not lead to such sharp drawdowns as a dividend gap. But a smooth decline is quite possible. For top managers, who during this period will be able to issue positive reports and get a bonus, this is good. It can also be beneficial for those shareholders who managed to take part in the procedure and sold their shares on the “hays”. For investors who bought shares based on a steady increase in the results of the transaction, this can result in a long and deep drawdown. That is why experienced investors sometimes take a short position on the eve of the buyback.
After completion of the consolidation, the volatility of quotations can greatly increase. This is due to the fact that the shareholders, who will be returned unredeemed paper, are likely to decide to sell them.
Special risk are buybacks on borrowed money. Usually, shortly before the buyback, the issuer places bonds on the market. The risks of the investor are that the company, having burdened itself with debts, will not necessarily get the desired effect from the repurchase of shares. Then not only shareholders, but also holders of bonds can suffer from a possible default . This is unlikely with large highly liquid companies, but it is quite possible with issuers from the second and third echelons .
Logically, buybacks are relevant during stock dips. When buying out its assets on a drawdown, the issuer has two main goals:
- support capitalization, pushing quotes up due to a change in the balance of supply and demand;
- buy assets at an attractive price, with a possible return to the market after a price increase.
However, in recent years, this is increasingly happening not on the collapse of the market, which would be natural, but on price peaks. In the structure of stock purchases, the share of households and investment funds falls. But in an unnatural way, the share of corporations, which have become the largest buyer, is growing. The overheated market in 2018 is largely the result of the “bounce” fever. Only an increase in the rate to 2.25–2.5% and outflow of cheap liquidity somewhat slowed down this activity and led the market itself to a correction.
In this sense, the buybacks on the Russian stock market can be called more “healthy”. They do not rely on cheap liquidity, they are not of a rush, and do not occur in an overheated market. However, it must be borne in mind that the market volumes are incomparable, and the transactions themselves are single and have a lower success rate. In the Russian Federation differ in the direction of greater severity and regulation. So, for the consolidation of more than 25% of the shares is required to obtain consent from the meeting of shareholders.