With investment trusts increasingly deploying share buybacks as an instrument to control share prices, investors are likely to be (quite fairly) asking their advisers about the topic and what it could mean for them.
With that in mind, Chetan Sehgal, lead Portfolio Manager of Templeton Emerging Markets Investment Trust (TEMIT), reminds us not just what share buybacks are and why they can be beneficial to shareholders – but also points out a particular disadvantage too.
What is a share buyback?
A share buyback is when a public listed company buys back its own shares. This can be done in several ways, either through the open market, through a tender or through specific schemes of capital reduction. In addition to dividends, this is another way in which a company can return cash to its shareholders, thereby creating value for the shareholder. Share buybacks could be viewed by investors as a signal from the management board that it believes the shares are currently undervalued, and that the company’s prospects are stronger than the market anticipates.
What are their advantages?
Buybacks can be beneficial to shareholders in several ways. These include:
- Reducing the number of outstanding shares, which results in an increase in earnings per share and an improvement in financial valuations.
- By increasing demand for shares, buybacks can support the company’s share prices and lower the overall share price volatility of the security.
- Buybacks can prove to be more tax-efficient, since the withholding taxation associated with buybacks are typically lower than dividends.
Things to consider
We believe that a security can be considered undervalued only if one ascertains that a buyback of shares adds value to the outstanding residual shareholders. Thus, for us, buybacks need to be completed at prices which make economic sense from the point of view of the outstanding residual shareholders. Moreover, the shares bought back by the company should typically be cancelled rather than reissued on the stock market at a later stage, or the terms of reissuance should be clearly defined at the time of the buyback as to not disadvantage residual shareholders.
Friend or foe?
With the above caveat in mind, in general, we prefer buybacks as opposed to dividend payments, though both indicate good corporate governance and free cash flow generation.
However, share buybacks can also have some disadvantages. Among which is that it can reduce the free float of the company’s shares, which lowers the weight of the security in an index. This could subsequently result in index trackers and exchange-traded funds reducing their holdings in the company.
Overall, we believe that share buybacks can be a useful tool for companies to manage their capital structure and provide value to shareholders.
