This article appeared in the February 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Owen Richards, AIA
A share buyback is simply an offer a company makes to shareholders to buy back some of its own shares - either off-market or on-market.
For retail investors, the most common form of off-market buyback is an equal access scheme where the company offers to buy back the same percentage of each shareholder's ordinary shares. Some off-market buybacks may involve a tender process, under which shareholders are able to tender their shares to the company at discounts of up to 14 per cent (at, say, 1 per cent increments) to the market price.
Off-market offers were particularly prevalent in the year or two leading up to the GFC, until its consequent effect on the sharemarket. At that time a number of Australian companies, especially miners, banks and wealth managers, were holding excess surplus cash and had a large supply of franking credits.
The buybacks consisted of a declared capital component, up to the maximum of 14 per cent above market price, together with the taxation benefit of treating the portion of the buyback price in excess of the capital component as a fully franked deemed dividend.
Companies regarded this as good capital management to improve or maximise shareholder value, although some critics saw it simply as a tax dodge financed by the taxpayer (although fully approved by the ATO). It may simply be that directors considered investing surplus cash in the company's own shares was a better business opportunity than most alternatives available at the time.
Buybacks are, not surprisingly, very attractive to shareholders, especially those on a tax rate lower than the corporate rate of 30 per cent.
An example are investors that have an SMSF paying 15 per cent tax, as well as those SMSFs that have started an allocated pension paying zero per cent tax. These owners are able to either offset the excess tax credit against other income or to have the excess credit paid back in cash. The capital component was usually struck at a low amount and some shareholders could also use these losses to offset capital gains, which further improved the tax attractiveness of off-market share buy-backs.
In recent years there has been an increase in on-market buybacks. This is also cited as good capital management, but does not necessarily provide the same obvious benefit to shareholders. However, there are still a number of indirect advantages, especially in signalling to the market that the company believes its shares are undervalued.
If the share price declines, the buyback effectively costs the company less and, as shares are bought back, the number on issue decreases and the earnings per share (EPS) should increase.
An on-market buyback can also increase a company's return on equity (ROE). This effect is greater the more undervalued the shares are when they are repurchased. Buybacks also raise the demand for the shares on the open market because the company is competing against other investors.
In off-market buybacks, the company sends shareholders an offer document, explaining why it is making the offer and the steps it is taking to do this.
Most buybacks are within the so-called 10/12 limit that can be made at the discretion of the board. These involve 10 per cent or less of the total shares to be purchased within a 12-month period. Amounts over 10 per cent require the approval of a majority of shareholders and put a more onerous requirement on the company.
On receipt of the offer, each shareholder must decide whether they want to sell. If you had been thinking of selling your shares anyway, selling them back to the company as part of a buyback offer will at least save brokerage fees.
If you are happy with the company's future prospects, and any possible tax concessions are not an inducement for you to sell, you may decide to keep your shares and you will not be required to dispose of any of them.
The on-market buyback is also subject to the 10/12 rule and requires the company giving notice to ASIC and ASX. Any director or related party participation must be advised separately. The process is effectively a "first come, first served" offer by the company to buy back its own shares from shareholders at the current share market price in the ordinary course of trading.
Every day the offer remains active, the company must lodge a daily notice of the quantity purchased. When a company has reached its stated maximum number, or has bought back all the shares it needs, it provides ASX with a final buyback advice. However, this last form may effectively be delayed forever if the maximum number is not reached.
Other points of view
Some investors are not fans of share buybacks, claiming that many of them are little more than an effort by some companies to clean up their share registries by removing small shareholders. Other investors see them as a ploy by management to meet performance targets (through improved ROE and EPS), which can then trigger management's share options.
Another view is that a high percentage of companies have underperformed, both financially and in market growth, in the years following a buyback, and that therefore a buyback should be an exit signal for long-term investors. That holds unless the share price is at a significant discount to the intrinsic value of the company, and the directors and management are also buying considerable quantities of shares during the buyback.
The year ahead
It has been said that the future is promised to no one. That certainly seems to apply to investors and traders. However, indications are (although the Queensland and Victoria flood effects are not entirely known) that a strong year's growth in the sharemarket is expected. Unfortunately, that was what the market experts also said at this time last year, yet we finished with a minus 2 per cent whimper rather than the 15 per cent bang that some again forecast for 2011.
Assuming the positive forecasts come to pass, it is probable we will see some significant share buybacks. Many resource companies are cashed up and corporate Australia is said to be holding more than 30 per cent of total assets in cash, the highest percentage for more than a decade. BHP Billiton is probably the standout case. Many expect a modest dividend increase from the world's biggest miner but a significant share buyback is anticipated, particularly if a major acquisition is not made or planned first.
About the author
Owen Richards has been a trader for some years and is a member of the Australian Investors Association previous editor of its Equities Bulletin and a contributor to local and overseas trading magazines. The AIA is an independent, non-profit organisation aimed at helping its members become more successful long-term investors. It holds regular meetings and seminars, which can be viewed online.
ASX glossary of sharemarket terms helps investors understand the language of investing in listed products. Use it to learn more about any unfamiliar terms or descriptions.
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