In an illiquid market share buybacks in the open market may be tantamount to market rigging
Stabroek News
May 21, 2004
Dear Editor,
I am writing in response to recent comments which have appeared in these pages advocating the use of share buybacks as a means of returning capital to investors who hold shares in a company. Buybacks have grown in popularity in developed markets in recent years, particularly during the bull markets most of these markets experienced over the 90s. I myself advocate the use of buybacks - if a company has shown consistently good returns yet its share price does not reflect this, then the company can indicate its commitment to adding value to shareholders by buying shares from them at a price higher than currently offered in the market.
A buyback is essentially where the company buys its own shares. The effect of this is to simultaneously reduce both the amount of cash and the amount of equity (share capital and reserves) on its balance sheet. So the overall value of the company should be reduced by the amount of the capital spent to buy shares. So one might ask what the advantage of a buyback is. By reducing the size of a company's equity, this will improve the fundamental performance of the remaining shares - e.g. if the number of shares outstanding is cut in half, all other things being equal then both earnings per share and return equity will double. So an investor who buys or holds a share on the basis of the price earnings ratio or dividend yield may find the remaining shares more attractive.
There are two main ways share buybacks can be carried out 1) Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all their shares within a certain time frame at a price usually higher than the current market level. 2) Companies can buy shares on the open market over a long-term period.
In an illiquid, developing market such as Guyana, I do not advocate the open market for making share buybacks. Since most companies whose shares are traded on the exchange in Guyana have annual cash flows several times the value of all shares currently being offered in them, a company buying its own shares in the market could easily use the buyback process to swamp the impact of other orders coming into the exchange. Buying up all the shares on offer would bid up the share price which leads to the possibility that the company could be using this mechanism to effectively set the price at which its shares are being traded in the market.
The price movements could far outweigh any theoretical change caused by improvements in the ratios due to a lower number of shares remaining. Since there is a limit to how many shares the company can buy, as soon as the company stopped supporting the purchase of shares at that price, the price would be likely to fall back to the levels close to the level before the buyback starting - a false market would have been created during the buyback period.
Another concern I have of buyback in the open market is that the company is under no obligation to continue to buy shares, so it is a first come first served situation. Those who put their orders to sell in first may benefit from the increased prices, but buyers would then need to outbid the company if they wanted shares. When the company stops buying, the other shareholders may be left without buyers at those prices and may only be able to sell at a lower price. By comparison a tender offer provides an equal opportunity to all to take part, with no possibility of the action being seen as rigging the market. Of course in deep liquid markets the concerns arising from open market buybacks are mitigated because the usual turnover in the stock would probably swamp the orders from the company in any case. However we are a long way from that in Guyana.
A final observation is when is a buyback good for investors? If the share is undervalued then engaging in a buyback is a clear sign from the management the company supports the interest of the shareholders since it shows they consider it is better for the cash to be in the shareholders hands than remaining in the company. A large dividend could serve the same purpose, buyback signals an even stronger signal - since it can be thought of as an investment by the company in itself - that there is no better investment than this. However if the share is overvalued then the company may be better off using the cash to invest in new projects since these are likely to generate a higher return on the investment than the return currently expected on the share. A buyback in this case may be seen as an effort to prop up falling ratios, and once the support stops there may be little else to support the price at that level.
Yours faithfully,
Patrick van Beek
Editors note:
We sent a copy of this letter to Mr Christopher Ram, who raised the issue of share buybacks in Stabroek Business, (14.5.04) for his comments and received the following response:
"There is no conflict between the article and Mr. van Beek's very informative letter. His letter deals with buybacks generally while the article refers to the specific case of a company (Banks DIH) whose shares its CEO is convinced is undervalued by the market. Mr. van Beek supports the position that in such a case a buyback is good for the shareholders.
I am not as concerned, as Mr. van Beek seems to be, about market rigging due to share buyback by a company. The more present danger for our fledgling securities industry is the danger from the combined roles played, sometimes simultaneously by key persons/entities in public companies while also operating as advisers, dealers and brokers."