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Can investment premise be based on buybacks?

Can investment premise be based on buybacks?

Can investment premise be based on buybacks?
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By CNBCTV18.com Jan 25, 2023 5:15:01 PM IST (Updated)

While buybacks indicate that the company has a cash surplus, which can be treated as some margin of safety because the business gets valued ex-cash in practical terms, again, a large cash surplus should not be the sole reason to decide to invest.

A few things have caught eyes recently: Meta spent a whopping 45Bn $ on buybacks in 2021 at $330; BP announced another buyback of $ 2.5Bn; in the Indian context, 2022 has been incredibly kind to Indian shareholders as the total buyback value for CY 2022 is more than 24,000 crore (the exact number was 13,241 crore for CY 2021) and the Infosys buyback of 9,300 is yet to start. Indian companies have been very busy this year, looking at more than 40 buybacks announced this year, of which six are currently underway or about to start.

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The natural question to any investor’s mind is, can an investment premise be based on a company’s buybacks? Companies do buybacks by using their free reserves for one of the following three reasons:
● When Mature businesses, for example, IT companies like TCS & Infosys, have substantial free cash being generated but don’t have enough opportunities to deploy the cash for inorganic growth, they look to return surplus cash to their investors. In the last five years, Infosys always had surplus cash of more than 20,000 crore on its balance sheet, but it hasn’t made any major acquisitions, so it did buybacks of Rs 13,000 crore in 2017, Rs 8260 crore in 2019, and Rs 9200 crore in 2021.
● When companies have windfall gains due to unprecedented and favorable business environments, leading to substantial free cash, they consider sharing a part of this windfall with the shareholder through buybacks. Many global oil companies have seen their profits soar due to higher energy prices in 2022, and hence the likes of BP are getting into mega buybacks.
● Companies also announce buybacks as a signal to markets when the management feels that the stock is undervalued.
So companies announce buybacks to boost the total returns to the shareholders; it’s efficient utilization of surplus cash as well, and it’s accretive to the financial metrics of RoE and EPS. In a buyback, the number of shares bought back by the company get extinguished, thus reducing the total outstanding number of shares, and hence earnings per share (EPS) increases which reduces the PE multiple, making the valuations attractive.
While generally, buybacks indicate that the business is generating surplus cash and PE gets lower after the buyback, premising an investment solely based on the buyback history of a company may not be a prudent investment decision.
Buybacks in India are a more tax-efficient way to distribute the cash to shareholders (primarily promoters, as the majority is with them who are in a high tax bracket as dividends are now taxable in the hands of investors. Buybacks are taxed at 23.30 percent (20 percent Tax plus Surcharge and Cess over it) of the distributed income in the hands of the company and are tax-free in the hands of the shareholder.
While buybacks indicate that the company has a cash surplus, which can be treated as some margin of safety because the business gets valued ex-cash in practical terms, again, a large cash surplus should not be the sole reason to decide to invest. Many PSUs like Coal India and NMDC have had significant cash on their balance sheet and are monopolistic businesses, but the stocks haven’t delivered significant total returns to shareholders due to inefficient capital allocation in their businesses.
For listed Companies, there are two ways to buy back shares:
1. Tender offer: The Company offers to purchase the shares directly from the shareholder
2. Open market purchases: The Company announces that it will buy its shares from the open market at up to a maximum price.
On November 16, Sebi came out with a consultation paper on which comments may be sent by December 1, 2022. Apart from other changes, Sebi has proposed to the Government to shift the tax incidence from the Company to the shareholder.
Buybacks have always been popular and are gaining further popularity, along with the market regulator looking to streamline regulations to enhance transparency. So as an investor, one should be happy if some of the companies in his portfolio announce buybacks as it’s more tax efficient than dividends, but to base the premise to invest in a company purely on buybacks and cash surplus would not be a prudent thing.
But the companies that show the holy trinity of “free cash flow generation,” “consistent and sustainable business growth,” and “a liberal policy to return free cash to shareholders” are worthy enough to be considered for investments.
The author, Rahul Bhutoria, Director and Co-Founder at Valtrust
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