Buyback or Dividend Which is Best For Retail Share Investors?

Buyback or Dividend Which is Best For Retail Share Investors?

by Mr. Kunal Thanvi, Research Analyst,

Last year we attended lots of annual general meetings (AGM) across the country. A typical AGM is, at heart, a conversation between a company's shareholders and the management.

I remember an interesting conversation between a shareholder and a promoter of a small-cap company last year. The shareholder, in poetic style, congratulated the company for its good financial performance, saying...
I congratulate the company for yet another good year of performance and request the management to consider a special dividend and bonus next year.

Some shareholders have been with the company since the initial public offering (IPO). And in some cases, dividends are their only source of the income. They demand dividends, special dividends, and bonuses.

That said, last year the AGM was divided - i.e. between retail investors asking for dividends and bonuses and analysts asking for 
'buybacks' for real price discovery.

This takes me back to the scene from the same AGM last year...

Analyst: Sir, we have good cash on our balance sheet and recently finished our expansion plan. Should we expect a buyback next year?

Management: Yes, we are planning to use the excess cash either to pay dividends or for a buyback.

The retail investors were not happy to hear about the buyback and things got little chaotic. They didn't want to tender their shares back to the company and instead demanded a dividend.

Why the sudden surge in buybacks?

In last year's (2016-17) budget, the finance minister announced a special tax of 10% on dividends above Rs. 10 lakhs in addition to a distribution tax of 20%. Many companies went on to declare dividends after the announcement. And those who missed the bus are now taking the share buyback route.

In a buyback, the company purchases its own shares from the stock market. Subsequently, it cancels them or keeps them as treasury shares. The whole buyback process reduces the company's outstanding shares.

A buyback could mean the company has adequate cash to buy its own shares and is willing to reward its shareholders. It could also mean an improvement in financial ratios such as earnings per share, return on assets, and return on equity.

Apart from the above, buybacks make a lot of sense for companies now as they've become more tax efficient in India than dividends.

In 2016-17, buybacks were at a six-year high with 41 companies announcing a buyback against just 16 the year before.

So what should long-term investors do..?

There's no doubt that tendering a part of your shares in a buyback could be a tempting proposition, especially if the buyback price is higher than the market price.

However, it's important to understand that buybacks reduce the number of outstanding shares. Thus, the shareholders who don't tender their shares end up with a bigger piece of the pie.

Doing nothing during a buyback may not be satisfying to many investors. Receiving cash may seem to be a better option.

But remember, if you really are a long-term investor, buybacks will increase the value of your existing shares. The reduced number of outstanding shares will boost per share earnings (EPS) as well as ROE. And in the long run, these two measures matter more than anything else.

In all, we believe investors should consider buybacks on a case-by-case basis.

The Indian IT industry is right now going through a dull phase. In addition to the Trump issues, the excess cash on the balance sheet (due to limited growth opportunities) is resulting in falling return ratios.

For major players like TCS and Infosys, cash accounts for 40% of their total balance sheet size. And given the good correction in the valuations over the last one year, a buyback can be one option over dividends. 

In fact, TCS recently announced a buyback (refer the chart below to see the buyback in the historical perspective).

One of our Hidden Treasure recommendations also recently concluded a successful buyback. We recommended our subscribers not to tender their shares in the buy back, as the long-term prospects of the company are promising.

Buybacks can be seen as a healthy development. 
However, they'rejust one data point investors should look at. Ultimately, it boils down to management integrity, the company's moat, and the health of the company's balance sheet. 

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