[Aditya Bhayal and Prachi Tripathi are 4th year B.A.LLB (Hons.) students at NALSAR University of Law, Hyderabad]
Amidst the growing uncertainties surrounding the COVID-19 pandemic, the stock markets across the world have taken a beating in the past couple of months. Both of India’s benchmark indices, NIFTY and SENSEX, have registered lowest drops in over four years, as the market has slowly transitioned into the bear territory. Since there seems uncertainties surrounding the duration of the on-going crisis, some companies are betting on buybacks as a possible means to arrest the slide of slumping share prices.
Buyback is an exercise by which the shares and other specified securities are bought back by the company that issued them in the first place. After a buyback, the number of outstanding shares of the company shrinks, thereby lifting the earnings per share (EPS). According to section 68 of the Companies Act, 2013, the securities are bought back either (i) from the existing shareholders on a proportionate basis through a tender offer; (ii) from the open market via stock exchange or book building process; or (iii) by purchasing the securities issued to the employees pursuant to the scheme. A company funds its buyback through its free reserves, the securities premium account, or from the proceeds of issue of its shares.
There are many reasons why a company might opt for buyback, including reduction of outstanding shares, increasing EPS, or to improve the return on equity. But one of the major reasons why most of the entities endeavour to embark on this exercise is to augment and stabilize their share prices. As the COVID-19 virus wrecks havoc, many companies believe that their share prices have become undervalued and are therefore resorting to buybacks to reassure their fleeing investors. Buying back in a bearish market reflects companies’ confidence in their ability to weather this downturn. When companies feel that their stock prices are undervalued and fail to appropriately reflect the fundamentals of the enterprise, they might choose to go for buyback. This has an ameliorative effect on consumer confidence as the company tries to evoke positive sentiment amongst, send strong signals to and allay fears of the current and prospective shareholders. When a company eventually goes for buyback, the number of outstanding shares decreases thereby improving EPS and other metrics on the balance sheet leading to an increase in stock prices.
From the investors’ perspective, it is essential that the stock prices are not undervalued. Retail investors, who are not as savvy as their institutional counterparts in assessing the stock’s true value, come out as the biggest losers sometimes when the stocks are undervalued. It is difficult for them to decide whether to invest in such stocks or not, and they continuously run the risk of flawed analysis. In order to prevent the retail investors from missing out on an opportunity to invest in favourable stock – owing solely to undervaluation of the stocks – it is pivotal that the stock prices provide a true reflection of a company’s intrinsic value. Buyback can be a good way to remove this information asymmetry between the insiders (those involved in handling the affairs of the company) and the investors. Buyback also provides an opportunity to small shareholders investing with short term motive, to sell their shares at a premium and then to invest their money in other less risky ventures later.
While opting for buyback to raise the undervalued stock prices might be considered as a genuine activity, there exists several reasons why the said mechanism is not received warmly in the market. First, the stock prices are raised artificially as a consequence of share buyback activity. The company influences the market by announcing its decision to go for buyback, which causes an increase in the demand for the stock while reducing the supply. Based on the basic economic theory of demand and supply, stock prices usually rise in such a scenario. But, this sudden surge in the stock prices does not always portray the genuine credentials of the company. Many a time, these escalated stock price levels allure and mislead the non-professional retail investors into buying the stocks of the company undergoing buyback, eventually leaving them high and dry. Economist William Lazonick regards open market buyback as a tool for companies to manipulate their stock prices.
The second issue that plagues buyback is short-termism. The reduced number of outstanding shares post buyback provides short-term boosts to the company’s share prices and thus contributes to the stock price volatility. Buyback formulates a manipulative incentive system where the share value is shot up without any tangible change in the profitability, ingenuity, productive capability or underlying value of a given firm. Usage of the company’s financial reserve for buyback tends to benefit those who sell their shares and exit the company, as compared to the long term shareholders. Upon utilization of reserves to artificially boost up stock prices for short term pricing advantages, companies pay the opportunity cost of discounting investment in other long-term operational activities which facilitate growth of and create value for, both, long term shareholders and the company itself. Moreover, in the current circumstances, buybacks can disproportionately enrich the astute and opportunistic institutional investors, as compared to continuing shareholders and employees. Opting for a buyback mechanism to stem the plummeting share prices will leave companies with little cash on hand to pay furloughed employees or prevent pink-slipping, let alone reinvestment for job creation.
In the current pandemic scenario, using buybacks to arrest fallout in the markets will severely impact the liquidity of the company thereby reinforcing financial fragility and undermining the quest for stable and equitable economic growth. Furthermore, research on the issue has revealed that the myopic objective of buyback has been responsible for a national economy characterised by reduced innovative capabilities and economic instability in the long run. In the present time, where the economy is on the heels of yet another recession, the current boom in buybacks might potentially go against sustainable prosperity. Additionally, previous market studies also suggest that companies which opted for buyback underperformed in the long run as compared to its peers who refrained from indulging in the same.
Warren Buffet, inarguably one of the greatest investors of all time, had stated that two conditions should ideally be met before going for a share repurchase; first, that the stocks of the company are being traded below their intrinsic value and, second, that the company has enough reserves for its near term needs. In the current volatile circumstances, with no foreseeable end to the economic crisis, companies cannot possibly claim to have anticipated and provided reserves for all contingencies that may arise in the future. According to analysts, the coronavirus-led market thrust is of an unprecedented nature and is likely to have far more debilitating effect than any other market crisis in the past century. Previous bear markets in the history have been event-driven – one where the changes in monetary policies were adequate to arrest the slide. But even the most optimistic of economists are unable to predict the time it will take to bring the market out of this public-health driven situation which has been further exacerbated by lockdown and quarantine measures. In such unpredictable and tumultuous times, the decision to go for a buyback would be unwise to say the least, and in contravention to the second condition laid down by Warren Buffet.
Even though Indian companies are finding favour in buybacks, the situation is different in other parts of the globe, as the buyback figures are dropping drastically. Buybacks by S&P 500 Index companies are expected to fall significantly as the economy grapples with the fallout impelled by the pandemic. Evidence also suggests that buybacks tend to go out of favour in bear markets. This was observed during the 2007-09 financial crisis where the share repurchases fell by more than 75% in the United States. This reflects the cautious approach adopted by companies in times when the market volatility is at its peak and the economy is unstable.
With nationwide lockdown and consequent collapse in revenues owing to negligible operational activities, it is extremely uncertain if the companies can accumulate enough profits in the forthcoming months. In such a chaotic situation, it would be better if the companies have sufficient liquidity to act as a cushion in case the ongoing crisis extends for a longer period. Having free reserves at this juncture can be gold dust which could be utilized to cope and run businesses and the same should not be used to fund buybacks. Moreover, the major reason for buyback, i.e., escalation in prices of undervalued shares, might not be due to the poor fundamentals of the company but rather because of the fear and uncertainty surrounding the virus. Therefore buybacks might not be able to revive the stock prices for the companies in the present circumstances.
As the companies navigate through this period of uncertainties, they can tread on the side of caution by suspending their buyback activities thereby ensuring that they are sufficiently capitalized to withstand further hits from this economic breakdown.
– Aditya Bhayal & Prachi Tripathi