Understanding the Efficacy of Share Buybacks
Share buybacks are once again in a spotlight after a host of announcements made by IT companies including software behemoth TCS. IT companies with their asset-light models and profitable operations are big cash generators. 'Cash is King' goes a famous proverb. This is because companies that have substantial cash flows on their books have greater flexibility of taking timely business decisions. These decisions can range from acquiring a new business or expanding the current business. Basically cash offers companies a powerful option to make growth investments at the most opportune time and price. World renowned value investor, Warren Buffett, is a strong proponent of this philosophy.
While conserving cash for a rainy day is a good measure and imparts companies with a powerful moat, this practice should not become the norm. Cash being hoarded over long periods of time, instead of being deployed profitably in business, is a poor reflection on the financial foresight and capital allocation skills of a company. Moreover, as the accumulated cash earns sub-optimal returns it carries the risk of minimizing shareholder's returns (RONW) in the long run.
Therefore, excess cash on the books should be returned back to the shareholders. This can be in the form of dividends, bonus or right shares. Additionally, the extra cash can be utilized for share-buybacks by companies. Share buybacks help in value unlocking for a company. This is because through share buybacks, owners are reposing greater confidence in the company's future business. This helps in realizing the company's true valuations. Also the share extinguishment boosts earnings per share and shareholder's return. So share buybacks are a win-win situation for both owners as well as investors.
However, IT companies have only lately realized their importance.
They are quite generous with dividends. They payout anywhere between 30-50% of their annual profits. Additionally, they pay a special dividend every few years to flush out a little more.
However, this policy hasn't solved the RoE (return on equity) problem of IT firms.
Share buybacks are not very popular among the managements of these firms. There are two reasons for this.
Most of the senior managements in this industry are old-fashioned, conservative businessmen by nature. They do not like the idea of 'taking a call on the share price'. In other words, they're not too comfortable letting the world know that they think their stock is undervalued.
The second reason is more important: These stocks rarely traded cheap.
But now things have changed.
The cash piles have become too big to ignore.
The yields on cash parked in money market mutual funds have fallen from about 8% a few years ago to about 6% today.
The valuations of many IT stocks have corrected a lot over the last two years.
Also, managements have stated they will acquire not for size or growth but for strategic reasons. In other words, they will acquire relatively small firms to fill gaps in their company's services portfolio. Thus, huge cash reserves for large acquisitions are unnecessary.
Buybacks make a lot of sense now. The cherry on the cake is the tax efficiency of buybacks over dividends in India.
Companies that generate robust cash flows from operations manage their working capital effectively and have low reliance on external funds. Moreover, such companies are able to manage their finances better in an economic downturn and their deep pockets give them greater freedom for business expansion. However, cash accumulation over long periods of time without being employed optimally can minimize shareholder's returns. Therefore, companies should maintain a fine balance and not go overboard in hoarding cash.
You can check the top 10 companies having high Return on Networth (RONW) in the Stock Screener Module by clicking on 'Query on your own'. By selecting the industry and entering 'RONW', '>=', and '20' values in respective drop-down menus, you can run the query for the top 10 companies in an industry having RONW>=20. The query also gives the 1 year forward RONW values on these companies.
While conserving cash for a rainy day is a good measure and imparts companies with a powerful moat, this practice should not become the norm. Cash being hoarded over long periods of time, instead of being deployed profitably in business, is a poor reflection on the financial foresight and capital allocation skills of a company. Moreover, as the accumulated cash earns sub-optimal returns it carries the risk of minimizing shareholder's returns (RONW) in the long run.
Therefore, excess cash on the books should be returned back to the shareholders. This can be in the form of dividends, bonus or right shares. Additionally, the extra cash can be utilized for share-buybacks by companies. Share buybacks help in value unlocking for a company. This is because through share buybacks, owners are reposing greater confidence in the company's future business. This helps in realizing the company's true valuations. Also the share extinguishment boosts earnings per share and shareholder's return. So share buybacks are a win-win situation for both owners as well as investors.
However, IT companies have only lately realized their importance.
They are quite generous with dividends. They payout anywhere between 30-50% of their annual profits. Additionally, they pay a special dividend every few years to flush out a little more.
However, this policy hasn't solved the RoE (return on equity) problem of IT firms.
Share buybacks are not very popular among the managements of these firms. There are two reasons for this.
Most of the senior managements in this industry are old-fashioned, conservative businessmen by nature. They do not like the idea of 'taking a call on the share price'. In other words, they're not too comfortable letting the world know that they think their stock is undervalued.
The second reason is more important: These stocks rarely traded cheap.
But now things have changed.
The cash piles have become too big to ignore.
The yields on cash parked in money market mutual funds have fallen from about 8% a few years ago to about 6% today.
The valuations of many IT stocks have corrected a lot over the last two years.
Also, managements have stated they will acquire not for size or growth but for strategic reasons. In other words, they will acquire relatively small firms to fill gaps in their company's services portfolio. Thus, huge cash reserves for large acquisitions are unnecessary.
Buybacks make a lot of sense now. The cherry on the cake is the tax efficiency of buybacks over dividends in India.
Companies that generate robust cash flows from operations manage their working capital effectively and have low reliance on external funds. Moreover, such companies are able to manage their finances better in an economic downturn and their deep pockets give them greater freedom for business expansion. However, cash accumulation over long periods of time without being employed optimally can minimize shareholder's returns. Therefore, companies should maintain a fine balance and not go overboard in hoarding cash.
You can check the top 10 companies having high Return on Networth (RONW) in the Stock Screener Module by clicking on 'Query on your own'. By selecting the industry and entering 'RONW', '>=', and '20' values in respective drop-down menus, you can run the query for the top 10 companies in an industry having RONW>=20. The query also gives the 1 year forward RONW values on these companies.
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