In finance circles it is said: “Buybacks are divisive, they divide people who understand finance from those who don’t!’ But these days, even those who are experts in finance are divided.
Warren Buffet, in his latest annual newsletter, called stock buyback critics ‘economic illiterate’. On the other hand, Jeremy Grantham — market historian and a successful investor by his own right — recently criticised buybacks as they enable market manipulation amongst other things. Confused? Well, there is some truth to both. Buffet has caveated his view noting that buybacks add value if done at value-accretive prices. Jeremy Grantham’s point, too, has some merit as buyback announcements manipulate the market by causing imbalances between supply and demand, leading to arbitrage players taking advantage.
Plus, buybacks also signal that the management knows something!
Indian corporate boards and managements, especially from the IT sector (which makes up for a significant majority of buybacks), would do well to pay heed to this debate. With the record date for the Wipro buyback set for June 16, we analysed how well the buybacks in the sector have fared. The results are clear: unless done at cheaper value accretive prices, shareholders who did not participate in the buyback lose out.
Short cash/buy stock
Take for instance TCS’ buybacks announced in Q3FY21 and Q4FY22. The buybacks were done at a very pricey 34- and 44-times PE. Buybacks are transactions where cash is sold/shorted to buy stock.
The transaction works for the buyer of stock only when the intrinsic value of the stock is higher than the value of cash. Either earnings yield (1/PE) must be higher than the interest rate on cash, or an accelerating earnings growth environment must be ahead for the company.
Both were clearly not the case for the top players in the IT sector. This is reflected in the poor subsequent stock CAGR from the buyback price for most of the buybacks done in the sector in the last three years. TCS’ FY22 buyback involved buying the stock with earnings yield of 2.27 per cent by selling cash which could have earned well over five per cent.
However, the buyback done by TCS and Infosys in pre-Covid times when the stocks were trading at more reasonable multiples have fared better and have given decent, if not great returns.
HCL Tech, which did a buyback in FY19 at much more reasonable prices — at a PE of 16 times (earnings yield of 6.25 per cent) — has delivered the best returns.
Shareholders’ money
At the end of the day, buybacks are shareholders’ money returned to them, and so is the case with dividends. If the company does not have use for that cash, they are better off of returning it to shareholders rather than keeping it idle in their balance sheet or making a wrong capital allocation. To that extent, buybacks cannot be criticised.
However, the data from the IT sector over the last few years indicates that boards/managements could have distributed this money as dividends when the shares were expensively valued, the way HCL Tech and Tech Mahindra have done.
Buyback returns money to a few shareholders, while dividends return money to all the shareholders. In case of an overpriced buyback, those who participated (less optimistic on company prospects versus other uses of the cash) benefited at the expense of those who did not.
The taxation difference making buybacks via tender offer route more tax efficient could have been a factor as to why some managements choose buybacks over dividends. However, it needs to be noted that this comes with a signalling effect to investors, many of whom might be inclined to view it as an indication that stocks are undervalued. And why not? Wasn’t that one of the primary reasons why buybacks were conceived in the first place?