Beware of The Buyback Trap

Remember the summer of 2008? It was a time when the market was crashing down like a warplane shot out of the sky. During that phase of a declining market, companies resorted to various tricks and ideas to somehow hold their nose above water. One of such was the buyback gimmick which many companies, irrespective of the size and sector, flaunted to attract the investors’ fraternity. Some of these companies were successful in their bid and the drop in share prices was therefore milder but then in mid-2009 the prices of these companies spiralled upwards, leaving investors in a tizzy. All this has actually exposed the mentality of those companies which bluff investors with this buyback tool. If we go by the data of the companies who announced buyback of their stocks in 2008 and 2009, there have been 62 companies since January 2008 that have gone on a buyback spree and the total value supposedly earmarked by them was around Rs 5,919.52 crore. Forty companies out of these have already completed the exercise. “If we look at these completed cases, on an average these 40 companies have been able to buy back just 49.9 per cent of the total value announced by them earlier,” says Jagannadham Thunuguntla, Equity Head, SMC Capital. Certainly this is quite disturbing as many investors had been wooed to invest into these companies due to this buyback arrangement. “Only 14 of the 40 companies have actually honoured their commitment of buyback in full while some of the bigger companies like DLF, Bosch, Godrej and Monet Ispat have bought back just 13, 31, 29 and 24 per cent respectively,” Jagannandham adds.

 

Considering the above situation it seems that this buyback tool has been used by the companies to incite a positive movement in the scrip. It would also be pertinent to check if these companies had that kind of cash balance to finance their buyback plans, especially since the money markets during that phase were really tight. Surely, none of the companies wanted to dip into their cash reserves to indulge in buybacks.

 

To understand the basics of buyback we have to keep in mind that financially it is certainly a good sign in respect of the company that announces such a deal since, technically speaking, it means that the management of the company thinks that the intrinsic value of the company share is much more than the price at the stock market and so it makes sense to announce a buyback price which is much more than the market price. Also, especially in India where many companies are managed by families, a company’s management may not want to lose the smallest opportunity to increase their stake. The buyback option, therefore, works well.

Some companies have other reasons to go in for a buyback. “We did it to pull our debt equity ratio near to 1x, besides paying back to our shareholders and pulling our EPS up. We had ample cash on our balance sheet and so we opted for buyback. This way it has been of benefit to our shareholders,” comments a spokesman of SRF, which is among one of the few companies that has completed its buyback exercise in totality. But this is not true for every company. SEBI has, in the past, imposed some informal conditions and compulsions as to the number of shares a company would have to purchase every week during the buyback exercise period irrespective of the price of the stock.
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[INSERT_1] For investors it is significantly important to be diligent before parking their money in any company that has announced a buyback. “The best way to do this is by checking the cash balance of the company in its financial books and taking note of the fact whether it is in a position to fund its buyback exercise. This will give a fair picture about the intention of the management and reveal the truth about whether it really wants to buy back its shares or is it just a gimmick to lend momentum to a scrip’s price,” comments the CFO of a company. Considering that only 13 out of 62 companies have been able to achieve complete closure of their buyback since 2008, this homework on the part of the investors is essential.

 

Though these companies were shrewd enough to announce a buyback plan in 2008 and in early 2009 since the markets had been caught in a tail-spin, the recent bull run has played spoilsport to their game. At that time nobody had expected this kind of quick recovery in the scrips but as soon as it has happened, these companies found themselves in a Catch-22 situation. Since March 2009, the markets have witnessed a strange turnaround that has pulled up the prices of stocks, surpassing the maximum price announced by the company for buyback. Now it’s a real challenge for them to complete their buyback exercise as no shareholder wants to part with his shares at the price offered by the company.

This is what has been happening to a large part of the 22 companies whose buyback process is still going on. They have been able to buy back only 15.53 per cent of the value of shares of what was previously announced. Therefore, given the circumstances and the way the markets have moved over the past few months, it is very essential for investors to undertake some basic research before investing into any company that announces a buyback.

 

What Is The Legal Angle?

Buyback of shares is initiated via a special resolution of the shareholders of the company or a board resolution, depending on the percentage of shares to be bought back, and then a public announcement should be made, followed by disclosures and draft letter of offer filing with SEBI. This letter of offer would then have to be sent to the members of the company. Also, the buyback offer shall remain open for a period of not less than 15 days and not more than 30 days. But the biggest question remains: whether there is some minimum limit up to which a company has to buyback? As far as legal requirement is concerned, though there is no mandatory methodology purported by SEBI for computation of the minimum limit, yet the same has to be specified in the buyback offer document.

 

These days SEBI has given clear indication to companies that they should disclose and agree to acquire a minimum number of shares pursuant to a buyback offer. The SAT judgment in the case of Sasken Communication Technologies Limited makes it clear that a minimum offer size has to be disclosed and this minimum offer size is usually taken as 1 per cent of the maximum number of shares to be bought back. However, it is possible for a company to insert a condition in its offer document that any obligation to acquire the minimum number of shares is subject to such shares being tendered at or below the maximum price offered by the Company.” says Akila Agrawal, Partner, Amarchand Mangaldas, a renowned legal firm. “Considering that Companies usually draft their offer documents with adequate legal safeguards, in the event that the market price of the shares continues to be higher than the maximum price offered by the Company, it is possible for them to make a case as to why the minimum number of shares were not acquired in the course of the offer.” she adds. Now if that is the legal position of buyback offer then it is of utmost importance that investors should pay proper attention to the offer document to protect their interest and should not invest in companies blindly based upon just buyback cues.