Time for share buybacks

Published September 19, 2022

Profitable publicly listed companies have several ways to return excess cash to their shareholders. Dividend payments are the most common way, but a company can also choose to do a stock buyback or a share repurchase.

There’s actually a growing trend among companies in developed equity markets to do stock buybacks as their most favoured form of payouts to their shareholders. The trend is also catching up in emerging markets to return money that the companies don’t need to finance their operations and investments to their shareholders through buybacks instead of dividend payments.

In Pakistan, however, only a few companies like Netsol, Maple Leaf Cement, and Lucky Cement — have of late chosen this form of a payout.

A stock buyback happens when a firm uses some of its excess cash to repurchase its own stock from the marketplace. Once a company carries share buybacks, the break-up value of its stock and its profits per outstanding share increase as the total number of its shares goes down.

Corporate profits have doubled, yet minority shareholders have not benefited from the share price appreciation and resultant capital gains

Both stock buybacks and dividend payouts use cash to reward shareholders. The key difference between a share repurchase and a dividend payout is that stock buybacks potentially boost the earnings per share (EPS) and book value per share, while dividends always dilute the two.

Asim Wahab Khan, chief investment officer at NBP Funds, argues that it is an ideal time for corporates in Pakistan to initiate their stock buyback programmes. Why so? From its peak of 53,127 points in May 2017, the benchmark KSE-100 index of the Pakistan Stock Exchange has tumbled by almost a fifth to around 42,500 points.

In the same period, corporate profits have doubled. Yet the investors or minority shareholders have not benefited from the share price appreciation and resultant capital gains. No wonder they are shifting their liquidity to inefficient asset classes with much higher returns. In a worst-case scenario, complete misallocation of capital will halt corporate expansions resulting in a further economic slowdown, according to him.

“While lack of public interest, due to economic and political uncertainty, has been a key reason behind the ailing share market, the blame must also be shared by market participants who have failed to generate substantial interest of investors,” Mr Khan, who has over 16 years of diverse experience in research, portfolio management, equities and fixed income, says in an interview with Dawn.

“Investors have suffered as they are lured into stocks with artificial volumes and price pumping, eventually leading to greed-based investment that almost always erodes their savings. The biggest loser of this trend and an underperforming shares market in the long run will be the corporate sector and with it, the economy of Pakistan. The listed companies have an excellent opportunity to turn around this dangerous trend while making excellent returns for their shareholders by utilising buybacks.”

Mr Khan insists that a buyback programme has many advantages for the corporates. “To begin with, it boosts return on equity (ROE) and EPS as well as generates value since the cash utilised for buybacks generally yields far lower returns if kept idle in the company.

“For example, even with record high interest rates, the after-tax yield on cash for companies is nearly 11 per cent versus the earnings yield on equities of 23pc, which is also higher than the ROE of 16-17pc.

“Premiums paid on recent mergers and acquisitions (Askari Cement, Sanofi, Wyeth, Karam Ceramics and ICI Morinaga) and deep discounts on replacement value all indicate that buybacks can create significant value.”

‘Investors have suffered as they are lured into stocks with artificial volumes and price pumping, eventually leading to greed-based investment that almost always erodes their savings’

Additionally, according to Mr Khan, a buyback signals investors that management is confident in the company’s prospects. “This adds trust, improves perception and greatly enhances the company’s overall image. It gives freedom to the shareholders as those who want to cash out, partially or fully, can do so by selling their shares to the company. Buybacks provide huge impetus to price, allowing for rights issue/offer for sale at premium prices.”

A buyback effectively means re-investment in a high-return business, which boosts shareholders’ returns. Investors assign a premium to companies that regularly engage in buybacks because of higher liquidity and reduced risks, boosting their share price and reducing their overall cost of capital.

Besides, profits earned on cash on the balance sheet entail an effective tax rate of 61pc (corporate tax + Super tax + Workers’ Profit Participation Fund + tax on dividends). A share buyback would save these taxes, enhancing after-tax returns for its shareholders.

Buybacks also have several advantages for capital markets and, in turn, the overall economy by encouraging a culture of savings compared to dividends, which may not get reinvested and are instead used for consumption, points out Mr Khan.

Further, buybacks generate a virtuous cycle, which starts with increased liquidity, improved investor confidence and perception, and reduced risk and cost of capital. “This means a boost to the stock market, attracting further liquidity that can be utilised to fund value-added projects, especially with the help of initial and secondary offerings.

“With more capital directed towards the efficient asset class, companies can expand and grow their businesses, generating sustainable economic activity and employment for the masses. More liquidity is also ideal for the brokerage industry, which primarily relies on market volumes.”

Historically, dividends were the dominant form of corporate payout in the United States. However, there has been a structural change in corporate payout policy where buybacks have surpassed cash dividends and have become the dominant form of a corporate payout.

Since 1997, the total amount of buybacks has exceeded the cash dividends paid by US firms, while the proportion of companies with share buybacks has increased to 53pc from 28pc during this period.

After the 2008 financial crisis, the buybacks in the US dropped to 86pc of dividends or $205 billion. Since then, they have grown to $876bn (or 160pc of the dividends) in 2021. In 2022, buybacks are slated to cross $1 trillion.

In India, buybacks have been on a steep rise. From 2009, when buybacks stood at $100 million or just 1pc of the dividends paid, Indian buybacks are up to a whopping $5.6bn or 38pc of the dividends. “The growth in buybacks in other markets like the UK, China, Turkiye, Vietnam and the Philippines is similar,” Mr Khan stresses.

He argues that the rules and procedures for stock-repurchase programmes should be relaxed to encourage companies. “The Securities and Exchange Commission of Pakistan has recently enhanced the buyback period to six months from three months. It should allow subsequent buybacks after six months instead of a one-year lockdown period. This will result in increased flexibility and frequency for corporates engaging in buybacks, increasing vibrancy of the capital markets which will further the benefits of buybacks highlighted earlier.”

Published in Dawn, The Business and Finance Weekly, September 19th, 2022



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