What is share buyback?

Changes in the dividend taxation rates in the 2016 Budget have led to changes in the ways corporates tried to reward shareholders. Essentially, dividends received became taxable at the rate of 10 per cent for large shareholders who received more than Rs 10 lakhs. However, the capital gains tax on selling shares remains at zero for equity shares which have been held for over 12 months.

A promoter can announce a buyback, extinguish some shares and cash in. At the same time, since the equity base shrinks in proportion, the ownership pattern remains unaffected. The government has been the biggest practitioner of the buyback concept, pulling money out of the accumulated reserves of PSUs rather than actually disinvesting. These two factors - changes in dividend tax and the government's reluctance to actually disinvest - have led to a massive swell in buybacks in the recent past.

At the same time, the spate of buybacks indicate one distressing fact. Well-run corporates don't deplete reserves via buybacks when they have more constructive things to do with their cash. Companies with expansion plans should try to finance plans via reserves since that's the cheapest route, rather than borrow or raise fresh equity. Ergo, corporates don't have meaningful expansion plans - that also gels with the collapse of credit offtake which has dropped to a 25-year low. Put it together and it becomes very difficult to trust GDP numbers asserting GDP growth at 7 per cent.

Anyhow, what should a trader do, if a company offers a buyback? Will it be profitable to buy shares off the market and offer those? First, obviously read the terms carefully. Second, factor in the news - the market price of the share will go up. Third, adjust expectations for the fact that the shares you buy will not all be accepted for the buyback. You will therefore, be left holding some shares after the transaction is complete. Fourth, if you've bought shares from the market, rather than offering long-term holdings, you will be paying short-term capital gains.

Despite those caveats, buybacks are often worth it. But it can be a very complicated process. To take an example, HCL Technologies offered a buyback in early April with a record date of May 25, at a price of Rs 1,000 per share. The stock was trading at around Rs 865 when the offer was announced and it moved between Rs 800 and 880 during the "live period". Eventually in mid-June, when the deal was processed, about 67 per cent of the offered shares were accepted for buyback.

Assume that a trader managed to buy a stake at an average price of Rs 850 - towards the upper end of that price range. Those shares were offered and two-thirds of the position was accepted at Rs 1,000. The price fell to about Rs 840 after the buyback and the trader sold at a loss. So, there was a loss of Rs 10 per share on the shares not accepted for tenders. Putting it together, the trader made a pre-tax profit of about 11 per cent (absolute) over a holding period of about three months. There will be both short-term capital gains tax payable and also STT (securities transaction tax). It was still a decent trade making about 8.5 per cent.

There have been several similar trades in the past year. Those experiences lead us to believe that there are fairly safe, if limited, profits to be had in most instances from going to the market and accepting a buyback. Note that the promoters' interests are completely allied to that of the minority shareholder in these cases. However, the profits will always be limited and subject to arbitrage as big players will get into the action.