July 29, 1997
Company buyback of shares will keep markets on a roll
How can a corporate prove that it is most investor-friendly ? Issue bonus shares, of course. This is the majority opinion of those who invest keenly on the stock exchanges of the country.
However, if the finance ministry and relevant decision-making authorities have their way, soon this might change. The most investor-friendly acts in the emerging scenario could well be equity buyback initiated by companies. This means that companies which are cash rich would rather buy their equity back from investors -- not as an investment decision as much as a restructuring option to meet the future.
The equity buyback is more bullish than what a number of observers think. In my opinion, it is important because it will enable companies to start looking at the business options available to it in a wider sense: I mean that companies which have been manufacturing engineering items always looked at engineering options as a nirvana in itself. What happened in a number of such companies, is that due to a poor perception profile and the inability to source new financing options, they grew the old-fashioned
way: they gave modest dividends and occasionally announced bonus issues.
The world however belongs to the intrepid. A number of such companies -- respectable, strong, competitive and liquid -- took a surprising hit during the collapse of the Indian stock market over the past three years. Observers were stunned: how could blue chips quote so low? Even though the businesses were solid, why did perception collapse to rock bottom?
We will not go into why this happened. Suffice it to say that had India's corporate sector been given the freedom to buy their equity from the existing shareholders, a number of important things would have immediately transpired:
Companies would have sent out a strong signal that they care about their shareholders (How many companies have issued a notice or an advertisement highlighting the fact that the stock market was not pricing their equities correctly and that their investors needn't worry since fair value would always be realised in the medium term? I mean, how many companies induced confidence in their shareholders in such a time of national distress?)
Companies will give announcements in the age of the equity buyback, stating that if the p/e of their stock dropped to below 5.00 (based on retrospective earnings), they would not wait to initiate an aggressive buyback. The prices would then never fall below that level because investors would be clearly aware of the safety net built into the pricing. When done over a variety of counters in the A list, for example, the sentiment of the entire market would turn for the better.
An equity buyback more importantly would have sent out a signal on the company's future. No company with a grey future would initiate a buyback. Only companies with an optimistic future would. The announcement of a buyback would therefore not just be interpreted as an operation within a limited focus; it would be interpreted for its future connotation.
A number of companies that had cash when the economy was buoyant in 1994 invested heavily on the stock market -- and lost when the market plunged. Had they option of buying their own stock, we would have had a slightly different scenario; equities would have shrunk and this would have imparted a bullish impact. Perhaps the bear market might never have taken place (one extreme). Perhaps the bear market might never have taken such a turn for the worse (another extreme).
Perhaps the best situation was when the market was flat. We had an interesting scenario: companies which improved their profits quoted for p/e multiples ranging from two to five. In instances where the company quoted at a retrospective p/e of two -- implying that anyone investing at that price would recover his investment through earnings in exactly two years -- it meant that the company's equity cost was 50 per cent. Assuming that the company operated with an employee base of 500 and returned a net margin of 10 per cent at the end of the year, the equity buyback initiated with the consent of the board (ten people at the most) at a p/e of 2 would earn the company a hypothetical return of 50 per cent ! Talk of labour efficiency !
The equity buyback would open up an entire new way of looking at businesses. Corporate executives could well debate a diversification project and say that a six per cent pre-tax return was lower than a 15 per cent pre-tax return which the company could
get from buying its shares. As a result, it made more sense to initiate a buyback and shrink than to ply inefficient assets and grow.
Companies buying equity in times when their shares are depressed, could later offer at a higher rate to a different class of investors in other countries who tend to put a better value on the industry that the company belongs to. I know of biotechnology stocks that are quoted far below their potential. It is a hypothetical argument but the respective managements could well, in the future scenario, buy back stock to an extent where, because of the high promoter's stake, apply for delisting and then do
an IPO entirely abroad at a p/e at least five time its prevailing p/e. You can make money when a stock moves from a p/e of three to a p/e of five; but when a p/e grows five-fold, companies create wealth.
One of the most interesting things that the equity buyback can do to India is to evolve us from chasing the big as a form of corporate fulfillment to respecting the small as a thing of beauty. Imagine a company with an equity of Rs 500 million saying that it would rather be a company with an equity of Rs 200 million.
I see an extension of this logic. Once companies begin to realise that being small is no handicap but perhaps a preferable alternative, a larger number of such promoters will start talking a language that is currently limited only to analysts on the stock market. They will start discussing return on capital employed (among the mundane ratios), they will start discussing economic value added (among the not so mundane ratios). The day of the Indian shareholder will have arrived.
The magic of the buyback will manifest itself in interesting ways. Just as we often argue that the p/e discounting of a company should rise following an issue of bonus shares, similarly the discounting of a company will strengthen following the announcement of a share buyback.
One of the reasons why the market could well be on a perpetual boil is because there will never be a dearth of rumours on the market: as soon a company has a good year, its p/e would rise far in excess of what it does now because of the latent possibility that it could always buy back some of its equity. In a sense we would then be improving the overall p/e discounting of the market when the economy is on a roll.
I have one hypothetical example to share with you on the power of the buyback. Nagarjuna Fertilisers has an equity of Rs 3.32 billion. In 1996-97, the company reported an EPS of Rs 4.50 by registering a bottomline of Rs 1.49 billion. The promoters hold 15 per cent.
The market price is Rs 15. The company paid a dividend of Rs 18 per cent -- which is paid after the company has paid tax at the rate of 35 per cent and 10 per cent as dividend tax. This makes the dividend a 26 per cent pre-tax cost to the company. Should the company decide to buy shares back at Rs 20 -- 33 per cent higher than the prevailing market price -- and the same is replaced with a debt instrument of 13 per cent interest, the impact of tax on the company could well become zero.
My estimate: the equity would be reduced to Rs 2 billion, the EPS could increase to Rs 7.50, the float will drop, the promoters' holding will increase and the stock will not drop below Rs 20.