Should you sell stocks in buyback

What is Buyback ?

A buyback, also known as a repurchase, is the purchase by a company of its outstanding shares that reduces the number of its shares on the open market.

Why investors Invest in stock? because they believe that stock is undervalued. So by investing in stock investors are trying to earn return. So why Companies want to buyback their own stock, in another word, why some company want to invest in themselves? Simple reason is they believe that the stock price is not representing their own financial strength.

Interestingly, Peter Lynch, in his book One upon wall street mention one difficult to understand point of view in very interesting way.

Exxon has been buying in shares because its cheaper than drilling for oil. it might cost Exxon $6 a barrel to find new oil, but if each of its shares represents $3 a barrel in oil assets then retiring  shares has the same effect as discovering $3 oil on the floor of the New York  Stock Exchange. – Peter lynch in One Upon Wall Street.

In his book, Peter Lynch also mentioned that there are 4 alternatives for buyback. 1. Raising the dividend. 2. Developing new product. 3. Starting new operations 4. Making acquisitions. By giving example of Gillette, He mentioned how final three are nothing but breaking business.

A buyback allows companies to invest in themselves. In buybacks, the shares are bought back by the company and are shown in the financial statements as treasury stock. It can be sold later if the company decides so. By reducing the number of shares outstanding on the market, buybacks increase the proportion of shares owned by enduring investors. A company may feel its shares are undervalued and buy them back to provide investors with a return, and because the company is bullish on its current operations.

A company can fund its buyback by taking on debt, with cash on hand or with its cash flow from operations.

Though in India, We removed them from balance sheet. If the company want to increase the capital, they need to take permission. When a company accumulates surplus cash and has no alternative investment opportunities or is not looking at any acquisition, then it can go for buyback of their own shares as Having large part of balance sheet as cash is not good sign for company. This reduces the capital base and results in higher earnings per share and Return on Equity.

Buybacks send a positive signal to the markets as the promoters and management believe that the share is undervalued and the company doesn’t need cash to cover future commitments such as interest payments and capital expenditures.

This is what theory say about Buyback, so the question is…

Should You sell stock in Buyback?

First question here to ask yourself is What is reason behind it? De-listing? To increase promoter shareholding? to Through away some Outsiders trying to buy controlling stake ? or to return excess cash to shareholder, or Boost Ratio, Or Recapitalization of some private equity investors or like Mphasis, or Tata sons.

There are some business, where the cash generation is far more than the need of it. Business like where R&D is very low, Whole business is boring. Like Oil and Gas.

If the company is De-listing then, you don’t have any other choice. Yes, there is different market for such stocks but its difficult for such stocks to find buyer. Best choice is to sell.

Here I want to mention Essar oil, though the company was De-listing, but it was not company which was buying, it was promoter.It was taking place for some special situation. You may choose to hold if that is not big amount like few stocks in your portfolio.

But if the company is buying back for some different reason. Like what reliance did in 2012. Valued Rs 10440 cr , one of the largest buyback and still through Open Market Operation. Another Recent example is Bharat Electronics Limited. If you checked it, then you will realize that after the buyback, ROE cross 15%, which is one of the attractive fundamental reason for investor. in such cases you have two choices. One hold. though in cases like Reliance, Its impossible to say anything. But in case like BEL, there is choice to sell part and hold another part.

If its for preventing the outsiders from taking controlling stake, As per CFA institute, Its not good. What is wrong in if someone is understanding your companies undervalued stock and trying to make it right by rewarding shareholders? That is what Activist Investors do. If that is the case, Just sell the stock, Company is not in right hand, Management is not performing their duties and they also don’t want to leave.

Returning excess cash to shareholders is nothing wrong. But here I want to mentioned Current situation in Indian IT industry. In fact why Indian, many other companies are doing this. When your business is in such situation that even if you start investing in business, it will not make any big change, but the business will keep generating cash, then its far better to make buyback and raise dividend.

If the company is trying to keep stock in strong hand by buying back stock from investors who don’t have faith in business, then its very positive. Ignore it and start buying stock f you believe that the business is good. How to identify? company is operating in industry with difficult situation but there are some sign of revival. That will even boost ratio also as it will reduce dividend liability in future and concentrate ROE also.

Last type, Which is not generally practiced in India but maybe in US its used. When there is one private equity investor, you need to give them return in certain span of time. If in that time frame, company failed to generate such return but holding cash on balance sheet, its better to make buyback. so Private Equity investors will receive some cash and free for investing it. Recently TCS came up with such type of offer. If you are retail investors its up to you what you want. Generally this type need to analyze such offer thoroughly.

Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options; to make due on the shares and options, companies buy back shares and issue them to employees and management

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About Ashutosh Tilak

Tracking Indian Capital Market since 2010. Finance Student, On this blog I am writing about finance and Investing. You can contact me or @androidashu & @InsideFinanc on twitter