Business

To Catch A Falling Market

Allowing share buybacks may help revive the Indian market. But guidelines are necessary to ensure corporate democracy

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To Catch A Falling Market
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WHY do Indian companies want to be allowed to buy back their own shares from the market? And why are so many people in the stockmarkets saying that this is the one move that will revive the sluggish sensex?

The idea of allowing share buybacks was first mentioned by former finance minister P. Chidambaram in his 'dream budget'; he proposed to bring it in through a revamped Companies Bill. But the UF government fell before the bill could be moved in Parliament. This time round, there were high expectations that Yashwant Sinha would announce the allowing of share buybacks in his budget. He made no mention of it.

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Post-sanctions, however, the proposal has been revived, with a core committee of secretaries under cabinet secretary Prabhat Kumar recommending it. Law minister Thambi Durai has given his assent and the stage is set for introducing the bill in Parliament.

But why would any company want to devour its own shares? How is it that every time Wall Street dips, the likes of IBM, General Motors, Wal-Mart and Novell develop a voracious appetite for their own stocks? Closer home, why are investors and corporates like Reliance, Bajaj Auto, Apollo Tyres and BPL salivating at the prospect of the government allowing buyback of shares?

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The logic is simple. In a falling market, if a company buys back its outstanding shares, the reduced number of shares will, other things remaining equal, result in higher earning per share which will impact PE multiples. When prices are weak, buy-backs not only help prevent further decline, but increase overall demand to drive prices forward. They signal the company management's confidence in its own stocks, encouraging investors to look to it more favourably and enhance overall corporate valuations. On Wall Street, therefore, companies buy back shares as a matter of routine corporate house-keeping function.

In India the move to introduce buybacks has stirred up a hornet's nest. Some analysts look to it as a fix for falling stock prices. Others look to it as a rational use of cash in rich companies. Still others think it is the only defence Indian companies have against hostile takeovers. But for many, buybacks will be a handle in the hand of unscrupulous managements to manipulate share prices at will. So where does the truth lie?A bit in each contention. This has queered the pitch of debate on buybacks. The issues:

Will buybacks help a falling market?

"If the floating stock is too much, PE ratios extremely low and company reserves healthy, stock buyback is a good way to improve shareholders' value and get them interested in beleaguered stocks," says Suresh Shetty, stock broker. "Sound companies that are a victim of the depressed environment like an Arvind Mills, or a Vardhman & Mahavir Spinning will see valuations improve when buyback is introduced," avers S. Srinivasan, vice-president, Kotak Mahindra Finance.

What about the average company and the general sentiment in the stock market? "It might create an initial euphoria but professional investors will look at the company's intention and core values," says Srinivasan.

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Empirical evidence in the US has shown that the average company experienced small above-market benefits for a day or two following a buyback announcement but premiums disappeared within a few days. However, one salutary effect buybacks are likely to have is that they will provide companies with an expeditious route to reduce capital and improve earnings per share while providing investors with an acceptable exit option if they are not convinced about the company's potential. "Provisions in the Companies Act like Section 100 and Section 391-394 enable reduction of capital by companies but it is a cumbersome procedure involving court sanctions. With buybacks, overcapitalised companies can use capital more optimally in order to reward shareholders and take proactive steps to improve valuations of companies," points out solicitor Hemant Batra of Kesar Dass B & Associates. Net result: company stocks get the valuation they deserve and the market gets less volatile.

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Are buybacks a rational use of cash?

Opinions are sharply divided on this and hence the constant dithering by the government on whether buyback should be allowed for treasury operations so that firms can buy shares when valuations are low and reissue them when values improve. Buy-back enthusiasts feel that the flexibility to enhance values when there are huge cash flows makes sense. "Rather than letting cash idle or use it for diversification into unrelated areas, especially in an era where core competence is the ruling credo, it makes sense to improve shareholders' value through buybacks. You have to earn on invested capital and if you have too much of cash, you can't do it. For, ultimately you are responsible to shareholders," says an analyst at ANZ Grindlays Bank.

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Votaries of buybacks, in fact, are all for buybacks both for capital restructuring as well as treasury operations. "What's wrong if a share is undervalued and a company buys it to privately place it with an institutional investor if the shares are sold at a higher price while factoring in interest cost for the holding period?" asks Jayant Dang, MD, Escorts Finance.

However, many others feel that in the Indian context where family managements hold controlling interest, buybacks would lead to misuse of company funds for manipulating share prices. "We aren't talking here about corporate America where 95 per cent of corporates are owned by insurance funds, pension funds and mutual funds. We are talking about owners as managers. Insider trading will be rampant," points out Atul Sud, MD, Strategic Capital. Market analysts point to the recent gyrations of Videocon's scrip on the BSE as a case in point. The Dhoots, promoters of the group, recently made a public offer to acquire 2 per cent stake of about 14 lakh shares at a price of Rs 140 per share which was more than double the prevailing market price. The scrip had started moving just before the announcement. BSE had to apply the margin circuit breaker. "Buybacks may be bold, market-making statements abroad, but the concern about misuse is genuine here," says Shetty.

What about buybacks as a defence mechanism against takeovers?

Here a small company called Raasi Cements has managed to unite corporate, financial and legal opinion on buybacks as armour against predators. Raasi Cements, with compounded annualised growth among the highest in the industry, high capacity utilisation and low overheads, could not protect itself from predator India Cements because, as chairman B.V. Raju lamented, "while predators can use funds to mount a takeover, the target is not allowed to deploy its funds to defend ownership." With the ghost of Raasi haunting many companies, the 2 per cent creeping acquisition route is unacceptable to corporates. "Corporate India is up for sale. Consider the market capitalisation of large companies, the low valuations on the BSE. They are ripe for hostile takeovers. Not necessarily bad for shareholders but shouldn't the promoter get the rightful premium for relinquishing control?" asks Dang.

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Will buybacks play havoc with debt equity ratios?

They increase the financial leverage of the company which may put a question-mark on debt servicing capacity. Buyback advocates have an answer: If solvency certificates are made mandatory from auditors and approved by the board, the debt equity ratio is immaterial. Anyway, this ratio isn't good at measuring debt capacity. A better ratio is debt to cash flow, they argue.

And on scope of share manipulations? "No promoter would like to do that if he has to come again to the capital market to raise fresh equity," says Dang. That could be reckless considering the track record of corporates. So, adequate disclosures are a must to protect shareholders.

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In the final analysis, buybacks are nothing but a corporate finance tool. Its efficacy and benefits will accrue according to the use and conditions to which it is put. "If companies are made to disclose the number of shares repurchased, the price of acquisition, cost of capital and impact of per share purchase, buybacks can become effective wealth-creating mechanisms," says Batra. On the other hand, they may turn out to be perverse if they soak up capital that could have flown into more productive investment in business projects.

"What is needed is better policing after the guidelines have been laid down," points out Sud. "Law and regulation must enable and not disable as the move to restrict treasury operations may end up doing," avers Batra. Once guidelines are in place, the issue of when, where and for what buybacks are to be made is best left to corporates themselves, with strong safeguards for the common shareholder. This is not just about further opening up the financial sector. It's about corporate democracy.

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