Buyback: What should a retail investor do?

An investor buys a stock with the intention to earn returns. These returns accrue over a period of time. So why would a company buy its own stock? To earn returns on itself? Sounds confusing? Well read on to understand more.

Time and again you must have come across this word "Buyback". In a buyback, the company purchases its own shares from the market. Then it often cancels them or keeps them as treasury shares. (Treasury shares are the shares that may have come from a buyback or may have never been issued to the public in the first place. These stocks don't have any voting rights and they don't pay dividends as well. Hence they are not included in shares outstanding.) The result of the whole buyback process is that the number of shares outstanding for the company is brought down.

But many wonder as to what should be their course of action when a company announces a buyback? Should one tender their shares or hold on to it for further returns. To understand a course of action, one needs to understand another important thing. That is, what are the objectives of the buyback?

The company may be buying back its own shares due to any reasons. The reason may be to increase promoters' holding or to delist the company. It may also be to pay back the shareholders the surplus cash that is not required by the business. This helps the company in improving performance ratios like earnings per share and return on equity. This simply happens because after buyback the number of shares outstanding and invested equity capital go down. The reason for the buyback could also be to support share value or to thwart takeover bids.

Suppose the company is cash rich and cannot find any suitable avenue to generate additional returns on the same. Then it is best to return the excess cash to the shareholders. So the company may use the excess cash to buy back its own shares.

Now let's us discuss what should we do if we find a buyback offer in the stockmarkets. As suggested in the past, we suggest that one should refrain from trading. It would be better not to buy shares just to participate in the open offer. One may well lose money instead as is discussed later. But if one is already holding the shares, one may very well decide as per the merit of the case.

Case 1: After the buyback, the company will be delisted

This is a no brainer. Please tender the shares. After delisting one may face difficulties in selling one's shares in the future.

Case 2: Buyback is to support share prices and improve future performance ratios

Here we need to go back to fundamental research of the company. If improvement in the performance is sustainable then it would make more sense to hold on to the stock for a longer period. Else one might think of tendering in part and holding the rest for the future returns.

Case 3: Buying the shares just to participate in the buyback offer

There are people who do buy the shares just to participate in the buyback offer. This is something that we suggest our readers to avoid. Why? Let us try and understand it better through an example of Goodyear India.

On 9th Feb 2010, Goodyear India made an announcement to start the delisting process and announced a share buyback. The offer failed due to an inadequate number of shares tendered for the process. The company made the announcement for the same on 17th June 2010. In the whole process share price of Goodyear India zoomed from Rs 186 on 8th Feb 2010 to Rs 360 on 19th May 2010. Finally it came down to Rs 250 on 17th June 2010. After that it never crossed Rs 300 and 18th June 2010 onwards the average price for this share is Rs 256.

Source: CMIE Database

From the above chart it is very clear that the most of the people, who were looking to make a quick buck bought shares at higher levels. However, as the buyback failed, these shares crashed down. As a result, these people were stuck with the losses, which could not be recovered subsequently as the share price did not go back to the peak levels.

Even risk-reward analysis shows that doing trade here was not a good idea at all. No one can predict the very outcome of the whole process. It is also interesting to note that the buyback offer document had suggested a price indication of Rs 245 only. So even in the case of successful buyback, the upside was very limited. It was just the market's greed that sent the share prices north of the buyback price. But it lured several innocent people in the process.

In this case, it would be better for the people to stay away from the company. It is important to remember that buybacks are for existing shareholders only. It should not be used as a means for making a quick buck because if the buyback offer fails then the short term gain may turn out to be a long term pain. At the end of the day, it is all about the fundamentals and intentions of the company announcing the buyback. It is important to understand the underlying reason before deciding on a course of action.