Buying Back the Shares

SHARE BUYBACK

Share buyback means a company buying back its shares from shareholders other than promoters. Company does it to increase the shares’ prices or delist, and this is done by either buying in the stock market directly, or asking shareholders to tender their shares.

A buyback offer is when a company buys some of its shares from its shareholders and extinguishes them. This is usually done from shareholders other than the promoters themselves, and is most often a testament from the management and promoters on the strength of the company, and their commitment to increase the returns for the shareholders. Market experts say it usually shows the confidence of promoters in the future of the company.

THE RATIONALE BEHIND SHARE BUYBACK

There are a number of reasons companies go for buybacks. The intentions could be to reward investors, improve financial ratios (such as price to earnings, return on assets and return on equity), increase promoter holding, reduce public float and check the falling stock price, reduce volatility and build investor confidence.

The following are the 6 main reasons why company offers share buyback:

1. To stop the fall in stock price.
2. In some situation company may want to bring down the public holding and increase promoters holding.
3. If the company sees there is no better opportunity to deploy its cash reserves then it may decide to buy back its shares.
4. The buyback may improve companies return ratios. If they reduce the total number of outstanding shares then the EPS (Earnings per Share) increases because EPS is PAT (Profit after Tax) divided by total outstanding shares. If the EPS increases then the P/E multiple decreases, and when P/E decreases, the share price increases to bring the P/E back to the higher levels. Other ratios like Return on Equity and Return on Networth also improve due to this.
5. When a company thinks its share price is undervalued.
6. In case of eventual delisting, some companies, especially foreign owned companies get into buybacks because they want to eventually delist from the Indian stock exchange. Usually, they don’t buy their entire outstanding shares at one go, but conduct these buybacks over a period of time and buy in tranches of 5% or 10%.

MODES OF BUYBACK

First of all a buyback is proposed in general meeting of the company which is then voted on and approved by the board of directors. Then they announce the buyback in a newspaper with all the details. There are two types of common buyback routes companies take, open market purchase and tender offer, i.e. one is done through open market purchase from the stock exchanges, and the second is done through a tender form.

•  When a company carries out buy back from the open market through stock exchange, there is nothing that you have to do except hope for a probable gain in stock’s market price. Company decides to acquire the certaisn number of shares to be bought back and fixes a price cap and can buy for any price up to that.
• When company makes an offer to buy shares through the tender route, it has to declare the number of shares and the specific price, at which shares have to be bought back directly from shareholders. Company sends a tender form to all its shareholders with instructions on how to fill the form and where they can mail or drop the form. This route ensures all shareholders are treated equally, however small they are.

Most companies prefer the open market route. Out of 19 buybacks offers received in 2011, 14 were made through open market mode and 5 were made through tender offer mode. The biggest difference between the two is that the price in the tender route is fixed.

CAN INVESTORS GET SOMETHING BENEFICIAL OUT OF IT?

A buyback usually improves the confidence of investors in the company because it sends signal to the market that the company believes the stock is trading below its intrinsic value and therefore its stock price rises.

However, past data reveal the stock can move in either direction after the buyback announcement, though it helps stocks in most cases.

Below mentioned are the few points, in what ways an investor can be benefitted from the buyback of shares:

1. Buy back at good premium may increase the stock price in share market.
2. As buy back of shares reduces outstanding shares, the EPS (EPS is calculated by dividing net profit by outstanding shares) may look good.
3. The ROA (Return on Asset) and ROE (Return on Equity) may improve by fall in outstanding shares and assets (in this scenario, excess cash).

Generally shares react positively to such announcements because buyback reduces the number of shares outstanding, which increases investors’ claims on dividends and earnings of the company and as these claims increases, so do stock prices.

Hereunder are a few instances of buyback announcement and its impact on the market prices:

• When this year in January, SEBI approved changes in rules to allow public sector units (PSUs) to buyback shares, as a result, shares of few PSUs soared 30-50% in the first 5 trading sessions.
• On January 20th, Reliance Industries Limited approved buyback of up to 120 million shares at a price not exceeding Rs. 870 per share from open market. The stock has risen 4% since despite the fact that company had reported poor numbers for the 3rd quarter. It was at Rs. 830 at the commencement of the buyback on February 1st.
• But the case is always not the same, Indiabulls Real Estate started moving southwards after the buyback announcement. The company announced a buyback on December 15th 2011, after which the stock fell 3% to Rs. 48.25 till 7 January 2012.

The price trend depends on various factors such as the market situation, the mode of the offer, i.e. tender or market purchase, the size of the offer, the difference between the offer price and the market price of the stock and the market’s confidence in the management’s intention to carry out the offer. The movement of a stock after the buyback announcement depends on valuations and the result can differ from company to company.

THINKING OF PARTICIPATING IN BUYBACK?

If you plan to invest in any such company which is going to buyback its shares, there are some guidelines and the few words of caution to be followed:

• You should not buy shares just because the company is working out a buyback plan. In some scarce cases, buybacks are announced to trigger certain favourable movements in stock price.
• It is important to consider the size of the buyback, buyback price and the duration of the offer, because if the buyback size is too small compared with the overall market capitalization of the company, the impact on the stock could be very small.
• Equally important to know what buyback route the company will follow, because if they will buyback the shares from the stock market, then the share buyback price is irrelevant to you.
• If the company is buying back from the shareholders then you have to look at offer size of the buyback, how much time is left for the buyback to take place, and what is the difference between the current market price and the offer price.
• Generally, companies only buyback a certain percentage of outstanding shares from the public and to know this fact is really important; because a few people who are not familiar with the process end up buying shares with the hope of sure-shot profit and later stuck-up with the remaining shares as only a part of their holding has been bought back.

Whatever decision you take largely depends on these variables, and they can be entirely different with every single case. Generalization of these variables in context of buyback offers would certainly lead to a blunder; you will have to evaluate each offer on its merit only.

SOME CLARIFICATIONS WITH EXAMPLE

Consider the example of Monnet Ispat Limited; announced the buyback of equity shares on Dec. 22nd 2011 with the maximum offer price of Rs. 500, and the prevailing market price of the share was around Rs. 358.

What do you think of this offer? Is it an opportunity with entirely the win-win situation?

Monnet Ispat Limited will be buying the shares from the open market and not from the shareholders, and the price of Rs. 500 is only the maximum price at which they can buyback their shares. This is the upper limit beyond which the company can’t buy their shares from the share market.

So, when Monnet Ispat Limited has set up a maximum price of Rs. 500, it only means that they can’t buy shares at a price over Rs. 500, instead they can buy the shares at any price below Rs. 500, and can certainly buy it at the Rs. 358 or so at which it’s currently trading.

Had it been the offer where the company had opted to buy its shares back from the investors directly, the 500 number had more importance, but then they would not have even chosen such a high number.

Monnet Ispat Limited announced that buyback offer is for shares not exceeding Rs. 100 crores being maximum offer size representing 4.97% of the total paid-up equity capital and free reserves. At the time of announcement, maximum offer price was at 40% premium.

Now is it possible that someone buys the shares at lowest possible level and then sells them back at Rs. 500 in a few days, pocketing around 40% returns?

This simply won’t happen because usually there are more shares offered for a buyback than the company actually wants to buy. Therefore, in this case they buy back the shares in the proportion of the over subscription. So one will only get a part of his/her shares bought back, and if the price comes down below purchase price after buyback fiesta then for disposing of the remaining shares he/she might have to wait for long.

Blaming Financial Innovation for Global Financial Crisis

FINANCIAL INNOVATION has a dreadful image these days. The 2007-09 financial crisis followed by Eurozone catastrophe and the lackluster performance of the global economy since, has led to ‘great criticism’ of innovation in financial domain. After all, dicey financial products and opaque mortgage-backed securities did play a dubious role in the run-up to the global crisis.

In recent decades, three particularly important sources of innovation have been financial deregulation, public policies toward credit markets, and broader technological change. At the outset, it is easy to tell why new financial products come about: they come about because people in the economy find them useful because they fulfill basic economic objectives of people in the economy.

But most of the innovations in the run-up to the crisis were not directed at enhancing the ability of the financial sector to perform its social functions. Some believe that with the complex structures of home loan securitization, financial innovation ran ahead of the capabilities of regulators. Hence – it is claimed – a better world economy requires control on innovation.

Subprime mortgage loans, credit default swaps, structured investment vehicles, and other more-recently developed financial products have become emblematic of financial crisis. Indeed, innovation, once held up as the solution, is now more often than not perceived as the problem.

Most of the critics have market-based innovation in their sights. There is an enormous amount of innovation going on in other areas, such as retail payment that has the potential to change the way people carry and spend money. But the debate focuses mainly on wholesale products and techniques, both because they are less obviously useful than retail innovations and because they were more heavily implicated in the financial crisis: think of those evil credit-defaults swaps (CDSs), collateralised-debt obligations (CDOs) and so on.

Angels or Demons
This debate revolves around a simple question: is financial innovation good or bad? But quantifying the benefits of innovation is almost impossible. And like most things, it depends. Are credit cards bad? Or mortgages? Is finance as a whole? It is true that some instruments—for example, highly leveraged ones—are inherently more dangerous than others. But even innovations that are directed to unimpeachably “good” ends often bear substantial resemblances to those that are now vilified.

It is in the nature of markets that there are some things which are indirectly socially useful but which in the short term will look to the external world like pure speculation.

Many people point to interest-rate swaps, which are used to bet on and hedge against future changes in interest rates, as an example of a huge, well-functioning and useful innovation of the modern financial era. But there are more contentious examples, too.

The credit-default swap is an even simpler risk-transfer instrument: you pay someone else an insurance premium to take on the risk that a borrower will default. These instruments offer insurance against a government default, makes many Europeans choke. There are some specific problems with these instruments, particularly when banks sell protection on their own governments: that means a bank will be hit by losses on its holdings of domestic government bonds at the same time as it has to pay out on its CDS contracts.

The much-criticized CDO, which pools and tranches income from various securities; is really just a capital structure in miniature. Risk-bearing equity tranches take the first hit when things go wrong, and more risk-averse investors are more protected from losses. The real problem with the CDOs that blew up was that they were stuffed full of subprime loans but treated by banks, ratings agencies and investors as though they were gold-plated.

As for securitization and credit-default swaps, it would be blinkered to argue they have no problems. Securitization risks giving banks an incentive to loosen their underwriting standards in the expectation that someone else will pick up the pieces. CDS protection may similarly blunt the incentives for lenders to be careful when they extend credit; and there is a specific problem with the way that the risk in these contracts can suddenly materialize in the event of a default.

But the basic ideas behind these blockbuster innovations are sound. Securitization—which worked well for decades—allows banks to free up capital, enabling them to extend more credit, and helps diversification of portfolios as banks shed concentrations of risks and investors buy exposures that suit them.
Rather than asking whether innovations are born bad, the more useful question is whether there is something that makes them likely to sour over time.

Greed is bad
There is an easy answer: people. When bubbles froth, greedy folk use innovations inappropriately—to take on exposures that they should not, to manufacture risk rather than transfer it, to add complexity in order to plump up margins rather than solve problems. But in those circumstances old-fashioned finance goes mad, too: for every securitization stuffed with subprime loans in America, there was a stinking property loan.

This argument has a lot of power. When greed takes hold, finance in all its forms is undone. Yet blaming the worst outcomes of financial innovation on human frailty is hardly helpful.
In simple terms, finance lacks an “off” button. First, the industry has a habit of experimenting ceaselessly as it seeks to build on existing techniques and products to create new ones. The economist Robert C. Merton has coined an evocative phrase “the spiral of innovation” to describe the dynamic tension of this process. Innovations in finance—unlike, say, a drug that has gone through a rigorous approval process before coming to market—are continually mutating. Second, there is a strong desire to standardize products so that markets can deepen, which often accelerates the rate of adoption beyond the capacity of the back office and the regulators to keep up.

As innovations become more and more successful, they start to become systemically significant. In finance, that is automatically worrying, because the consequences of any failure can ripple so widely and unpredictably. The earliest adopters of an innovation are the most knowledgeable; a widely adopted product is more likely to have lots of users with an inadequate grasp of the product’s risks. And that can be a big problem when things turn out to be less safe than expected.

The road ahead
How should policymakers ensure that consumers are protected without stifling innovation that improves product choice and expands access to sustainable credit? The first line of defense undoubtedly is a well-informed consumer. Consumers who know what questions to ask are considerably better able to find the financial products and services that are right for them.

Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.

Though the recent experience has shown some ways in which financial innovation can misfire, regulation should not prevent innovation; rather it should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes. We should be wary of complexity whose principal effect is to make the product or service more difficult to understand by its intended audience. Other questions about proposed innovations should be raised: For instance, how will the innovative product or practice perform under stressed financial conditions? What effects will the innovation have on the ability and willingness of the lender to make loans that are well underwritten and serve the needs of the borrower? These questions about innovation are relevant for safety-and-soundness supervision as well as for consumer protection.

Innovation, at its best, has been and will continue to be a tool for making financial system more efficient and more inclusive. But, as we have seen only too clearly during the past five years, innovation that is inappropriately implemented can be positively harmful.

In sum, the challenge faced by regulators is to strike the right balance: to strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit. Goal should be a financial system in which innovation leads to higher levels of economic welfare for people and communities at all income levels.

Monetary Policy and Stock Markets

Monetary Policy is the actions of a central bank that determine the size and rate of growth of the money supply, which in turn affects interest rates. It is one of the ways that the government attempts to control the economy. If the money supply grows too fast, the rate of inflation will increase; if the growth of the money supply is slowed too much, then economic growth may also slow.

When is the Monetary Policy announced?

The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy. The Governor of the Reserve Bank announces the Monetary Policy in April every year for the financial year that ends in the following March. This is followed by three quarterly reviews in July, October and January. However, depending on the evolving situation, the Reserve Bank may announce monetary measures at any point of time.

A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

Inflation refers to a persistent rise in prices. Simply put, it is a situation of too much money and too few goods. Thus, due to scarcity of goods and the presence of many buyers, the prices are pushed up.

Inflation rate is the measure of the rate of change of price and not the absolute change in price. Which means till inflation rate comes down to zero prices will continue to rise. It is inflation rate goes negative will prices fall. The comment about inflation rate going down only implies that the prices of food will not increase as fast as it was in the last few months, which does not imply that the prices are not increasing.

A tool to control inflation, which directly affects interest rates

Monetary policy is aimed at controlling the level of inflation & interest rates in the economy. To do that, the Reserve Bank tries to lower the money supply when prices are rising. How does it do that? By lowering the amount of money available with banks. Raising reserve requirements, i.e., the amount of money which banks must keep impounded with the RBI is one way. Another method is to sell bonds to the banks. When banks buy bonds from the RBI, money flows out from banks to the RBI, lowering the amount of money available for lending.

In times of inflation, RBI sells securities to mop up the excess money in the market. Similarly, to increase the supply of money, RBI purchases securities.

So by changing the money supply, the Reserve Bank can determine the level of interest rates. Higher levels of interest rates impact corporate bottom lines and discourage companies from investing. That slows down growth.

The fact is that RBI monetary policy has an effect on all investors. Let's take a look how.

The stock markets and money move similarly, in some ways. Why?

Most people attribute the link between the amount of money in the economy and movements in stock markets to the amount of liquidity in the system. This is not entirely true.

The factor connecting money and stocks is interest rates. People save to get returns on their savings. In true market conditions, this made bank deposits or bonds (whose returns are linked to interest rates) and stocks (whose returns are linked to capital gains), competitors for people's savings.

The markets, however, move to the RBI's tune because of the link between interest rates and capital market yields. The RBI's policies have maximum impact on volatile foreign exchange and stock markets. A hike in interest rates would tend to suck money out of shares into bonds or deposits; a fall would have the opposite effect.

Impact on stock market

In the West, where both the bond as well as the equity markets are mature, an increase in interest rates leads to more money flowing into bonds. Other things remaining the same that means less money for the equity markets. In India, the bond markets are not very much developed, and only the banks and primary dealers are active in that market. Since banks do not invest in equities, except marginally, there is no flow of funds from the bond to the equity markets. So the impact of monetary policy on the equity markets here is indirect, rather than through the direct route.

However, the RBI does have a more direct way of influencing the stock market. That is by varying the percentage of funds which banks are allowed to invest in the stock market. At present, the aggregate exposure of a consolidated bank to capital markets (both fund based and non-fund based) should not exceed 40 per cent of its consolidated net worth as on March 31 of the previous year.