Deciphering share buybacks

Newcomers like myself must have perused through all the market events on SGX and one of the most common title that comes up is either Company Share Buybacks or Disclosure of change in interest of Director. Today we are going to uncover how we can use this information to our advantage!

Company Share Buyback occurs when the issuing company purchases its own stock at the current market prices using their company funds while Disclosure of change in interest of Director occurs when members of the board of directors purchases the stock of the company in their own personal capacity.

Why Company Share Buybacks occur

One might wonder why a company would use cash to purchase their own shares when they were issued for the purpose of raising capital for growth in the first place.

Generally , companies purchase their shares on the free market to consolidate their ownership as they feel that their shares are undervalued at the current market prices . This is done for a variety of reasons and it is the investor’s job to find out why.

Here is a few possible reasons :

•      Company wants to increase shareholder value by lowering the floating shares
  When the company purchases its own stock on the free market, this drives up demand for the stock and hence in effect, the price of the stock. Shareholders are rewarded this way for their loyalty for being vested in the company. However, always consider the fact that this may not the true motive; companies also do share buybacks as they have run out of growth opportunities and do not wish to leave excess cash in its balance sheets.
•      Company wants to reduce the cost of equity
  Studies have shown that the cost of debt is in the ballpark of 4-8% while the cost of equity is >25%! This is because the interest on a debt is finite and do not extend beyond its repayment. However , shareholders expect dividends to be paid annually for the capital that they have invested in the company , an endless outflow of excess profits which surges alongside the profit levels of the firm. Therefore by reducing the amount of shares held by external parties, the firm pays less dividend and incur lesser costs!
•      Company is attempting to window dress their accounts
  A practice that may be regularly practiced by financial whizzes in the accounting departments of large corporations is to purchase large amounts of shares back right before their annual reports. This makes the financial ratios that we scrutinise when buying a counter, so much better. Earnings per share(EPS) increases due to a decrease in shares available in the market , assuming earnings remain the same. This snowballs to the Price to Earning ratio(PE) because with an increase in EPS, PE falls , assuming that the price of the share remains constant. With the simple act of share buybacks, investors are duped into believing that EPS and PE has improved and making the counter a profitable one.
  
  
  

One has to do his own due diligence and not count only on the annual reports to determine the True Value of a company by re-calculating the EPS and PE ratios and  excluding Company buybacks, especially if the company has been making constant buybacks.


Why Disclosure of change in interest of directors occur

Instead of the company buying it, the people operating the firm use their own personal money to purchase stock of the firm via the free market or excercising their options. In most instances, stock options are offered to the top hierarchy of the company to allow them to buy shares at discounted prices. This is beneficial to the investors in two ways ; reduce the cost of compensation to management(MORE PROFITS!) and it makes the management more motivated to work harder to increase the value of the shares as they will profit on it too!

A purchase of stocks on the free market is more desirable as it shows that the directors are willing to take calculated risks and this indicates potential upside to the stock. Directors may have access to knowledge that may help boost the prices of the market before it is even released! Following this insider trading may prove to be a worthy investment when the actual news is reported.

A case in point would be a firm most of us would be familiar with during its surge in share prices last month! AEM holdings increased multifold from 80 cents in the beginning of March 2017 and at the time of writing, it is $2.6! A three bagger in a matter of 3 months! Could we have caught this counter in advance to make a modest profits for ourselves? Maybe we could have! Prior to the announcement of its superb Q1 results, many board members began to accumulate shares for themselves as they knew that AEM was having a very prosperous quarter! If we could tap on their knowledge, we would be able to ride the waves of wealth as well!

However, one must conduct their own research before investing as this may not be a foolproof plan! An example would be the director of S i2i Limited, despite repeated insider purchasing by its chairman to raise his holdings to 32% the company , the company is not fundamentally sound as it has stagnant growth and falling cashflow levels.

As usual, the stars must all align before you make a purchase on the stock in order to maximise your chances of profiting from the market! Have a good investing week ahead!

For Honour And Glory,

CDOInvestor