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Arbitrage opportunities in share buybacks

March 27, 2022

by invitationThe share buyback offer of TCS which closed last week, attracted a record number of applications from investors who wanted their shares to be bought by the company and extinguished. TCS had offered to buy back shares worth Rs.18,000 crores at a price of Rs.4500 per share.  

I am not going in to the merits or absurdities of such an offer by the company and whether it is good or bad for shareholders. My focus here is clearly to see what strategy investors should adopt when it comes to a buyback. I am using TCS as an example, as it is current and has attracted applications for seven and a half times the amount of buyback that TCS has announced. Over ten lakh investors have tendered shares in this offer.

share buyback arbitrage, share buyback

Share buybacks and acceptance ratios

Tender offers for share buybacks are usually made at a premium to a stock’s prevailing market price, so shareholders often get to pocket gains by selling their holdings at a premium.  But as companies offer to buy back only a fraction of their outstanding shares, the acceptance ratio, or the number of shares that the company actually accepts in the buyback compared to the shares held, decides the extent to which an investor can pocket short-term gains from such premiums. There’s a reservation for retail shareholders (those holding less than Rs 2 lakh worth of a company’s shares) in share buyback offers giving them a slightly better shot at these gains. 

In TCS’ case, retail investors got an initial communication that 1 in every 7 shares held by them could be tendered for the share buyback, while for non-retail shareholders the ratio was 1 in 108 shares.

But such communications by companies are based on the shareholding pattern. The actual acceptance ratio could turn out better than the theoretical one if many shareholders don’t apply for the share buyback. In most cases of buybacks in the past, retail shareholders were not active participants. (Earlier, buybacks also used to be in the physical and not electronic mode, leading to poor participation.) 

This practice of companies pricing their tender share buyback offers at a premium to market price and retail investors generally not tendering their shares, has led to many brokerages promoting buybacks as an arbitrage opportunity. When the TCS buyback was first announced, most commentators assumed a 30 to 40 percent acceptance ratio as the worst-case scenario and encouraged retail investors (who didn’t own the share) to buy TCS in the secondary market, to tender in the buyback and pocket some easy gains.

No easy gains

But the market seldom gives opportunities for easy gains. So, the TCS share buyback on this occasion has turned out to be different, with the actual acceptance ratio for retail shareholders proving worse than expected. Unlike the past where TCS was able to accept all the shares submitted by retail investors, this time it appears likely that TCS would accept upto 25 percent of what retail investors hold. With calculations going wrong, the buyback arbitrage strategy has gone a bit awry. 

Unless TCS’ secondary market price moves up dramatically post buyback, there is not going to be a joyous ending for retail investors who played the arbitrage game. Once the offer closes, there could be some heavy selling of balance shares by those who bought only for the sake of the buyback, further denting prices.

Thin pickings

The arbitrage gains from a share buyback depend not just on the acceptance ratio, which is a moving target, but also on how market prices of the stock behave during and after the buyback offer. The TCS share buyback was considered by its Board of Directors on 12th January, 2022. Around that time the market price was close to Rs.4000 while the buyback price was Rs 4500. This gave one a gain of around Rs.500 if bought on announcement date and sold in the offer, a return of 12 percent for a two to three-month investment.

If the prices had started moving close to the buyback price by the tendering date, the gap would have narrowed down and dissuaded investors from tendering. However, in this case the market price has moved down, thanks to the broader market correction, leaving a larger room for gain if shares are accepted. This has likely resulted in a herd behaviour of many investors submitting everything they own, which in turns leads to a lower acceptance ratio. 

To illustrate, let us look at the various scenarios that were possible, if you had bought 50 shares at an average of Rs.3900 after the buyback was announced. 

Assuming different price levels for TCS shares, here is a table of various possible outcomes based on the following:

Purchase price per share: Rs 3900

No of shares bought: 50

Total Cost: Rs 195000

Buyback price: Rs 4500

Post buyback market price of share: Rs 3900

The above illustration tells you that if the TCS share’s market price settles at Rs 3800 instead of the Rs 3900 assumed, the gains on the arbitrage trade fall dramatically. You have to hope that the TCS stock price does not settle below Rs.3800 post buyback for you to break even.

Rules to play buybacks

Given that playing the buyback arbitrage entails so many uncertain variables, serious investors must question if it is worth the trouble.  

As far as I am concerned, it is best to use some rules before we buy in to a share after announcement of a buyback:

  1. If the acceptance ratios or arbitrage gains seem too good to be true, keep away. There is no legal obligation on a company to go through with an announced buyback and a company can easily keep putting it off or never closing it out. 
  2. Are you buying at a price at which you would buy this stock even if there is no buyback.? This is perhaps the most important test and if the answer is no, I would simply not buy the stock. 
  3. Was there a sharp run up in price before the buyback was announced? If yes, it is best to keep away.
  4. A buyback is not a confirmed assurance that the promoter or management think there is an improvement in profitability or outlook of the company. The motivation for a buyback need not always be returning capital to shareholders, as textbooks say. A buyback could be driven by tax reasons or a promoter wanting a good price for his stake by participating in it. We really do not know.
  5. Our reason for buying a share should be primarily the investment thesis about the business. A buyback is simply some additional opportunity.  

So let us not get carried away by buybacks. Buybacks do help the good companies by shrinking the capital base and improving earnings per share for investors who stay.  It is also a tool used by some promoters to increase their shareholding, without using their own money. They simply do a buyback at a high price, let the company buyback whatever is tendered within limits and stay off participating in it. I also am wary of companies with debt that engage in buybacks, when the cash could be better used to repay debt. This is often an attempt to boost share price / increase the promoter holding. 

When a good company does a buyback, it generally makes sense to hang in and not participate in it under normal conditions. If you look at the past history of TCS or Infosys buyback, the prices have generally gone past buyback prices in the long run. 

So the question to answer before participating in a buyback would also be a simple one. “If there was no buyback, would I sell at that announced price?” 

Thus, a buyback should not be viewed as a mere arbitrage, though favourable market conditions might make it look like one. Never forget that buying a share or selling one is always a call on the underlying business and not on its stock price movements.

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