Can a share buyback program solve our capital market problems?

Disclosure: The article was written on Wednesday, March 16, 2011 at 11:36am. It reflects the writer’s personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.

This writeup is definitely not one of my better pieces. I wrote it in a hurry because I think that raising awareness on this issue is a must. So please forgive any mistakes and errors.

Background

Instead of going after valid issues like insider trading, price/volume manipulation, monitoring and compliance we seem to go after the wrong issues. I am basically referring to the plan to use “share buyback” as a way to ensure that stock prices do not remain “undervalued”. How does this work? Basically, when a company feels that its stock is trading below fair value it uses its own cash to buy back shares. It is easier to think that share buyback is similar to paying cash dividend because the company pays cash to existing shareholders to buy the shares.

Share buybacks are allowed in many countries of the world and particularly developed countries. However, that does not mean that it has to be adopted in Bangladesh as well. In fact, given the current condition of our economy and market I think that it will be a big mistake to allow share buyback. This is my preliminary response to the idea and I will hopefully write more after I get the final copy of the guideline in hand.

Reasons

I will try to be very specific on the reasons I am going to cite.

1. A new method of stock price manipulation: Once legalized, company management and sponsors will now be free to use the rumors and news of stock buyback to increase stock prices. Now since it is going to be legalized the manipulators would not face any problem whatsoever.

Let me give an example. When the seller knows that there is a ready buyer for the stock, the seller will be able to hike prices. Given the highly speculative nature of our market this is going to be a ticking time bomb where retail investors will once again fall prey to the schemes of the manipulators. This will be the new fad after bonus shares, rights shares and stock splits all of which led to unjustified increase in stock prices.

2. Objective of capital market: A developing country like Bangladesh needs to invest a lot for growth. Capital markets are created primarily because entrepreneurs can raise funds for investment. When we are allowing buy backs we are basically doing the reverse. Companies will be giving back money to the shareholders. This is definitely counter intuitive. When most of the companies are unable to give decent dividend yields how would they be able to buy back shares? One way may be to use leverage which makes things even worse. Already our capital market is heavily leveraged and the banks are going to pay a price for that. We really cannot afford to increase leverage any more.

3. Supply of shares would decline: It is common knowledge that we have lack of supply of quality shares. Now if companies start buying back own stock we are actually decreasing supply rather than increasing it. How that helps is a big question mark.

4. Focus to be diverted away from operations towards financing activity: Allowing buyback will definitely divert attention of management and the directors towards financing activities instead of trying to improve operational capabilities. These days everybody is trying to get rich in the shortest possible time which is why we see manufacturing companies investing in the capital market. This is highly detrimental for the country as resources are not being used for productive purpose but rather for speculative purpose.

5. Who has the necessary cash balance?: The only companies who should go for buybacks are companies with huge ‘net cash’ position which are unable to use that money for productive purpose. Thus there should be a clear guideline on who can go for buy back. Like I already mentioned, leveraged must not be allowed at any cost to buy back shares. Now if we look at the listed companies there are only a handful of companies who has the required balance sheet strength to buy back. I am quite sure that once the buyback rule is passed its going to be the companies with the weaker fundamentals that will use it rather than the ones who should go for buyback.

6. What are the penalties for violating rules?: My last concern is violation of the buyback rules. This is a sensitive thing and involves huge amount of money. Thus violation of buy back rules must be penalized with hefty punishment like imprisonment. I guess the penalty aspect would be clearer once the final copy of the law is out.

Conclusions

Instead of focusing on complex things like buybacks, we should use this time to work on the basics first. The priorities in my opinion are

1. Strong insider trading laws: Insider trading is rampant in our market where everybody seems to know earnings and corporate declarations much before the company announces them. This is the biggest evil right now.

2. Preventing price and volume manipulation: This is the second biggest problem. Syndicates corner shares and then start spreading rumors. In finance terms this is called “pump-and-dump”. We need to stop this.

3. Corporate governance and transparency: No need to elaborate on this. In terms of corporate governance and financial transparency we fall far behind compared to most neighboring countries.

4. Bonus shares/Splits: It is high time that investors realize that bonus shares do not mean anything. They don’t add any value to the company and thus should not increase stock price.

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

4 thoughts on “Can a share buyback program solve our capital market problems?

  1. Great post ! and you made some very valid points on your blog, and I appreacite you sharing some of the concerns you have regarding rampant insider tradings going on in various companies. I am defintely not at all familiar with the Bangladesh Stock Markets, but I wonder if they have some independent governing body overseeing the markets, similar to the SEC (security & exchange commission) in Bangladesh? I am sure they have some sort of Gov’t institution overseeing the markets, but I fear that the system has been long compromised by widespread corruption. I feel that this will be a prime oppurtunity for a private institution to come in and establish themselves and develop a franchise similar to a rating agency (Moody’s) combined with roles of market ethics oversight. I would love to hear your thoughts and insight on this.

    Regards

    Shezan Ahmed

  2. Brother,

    Presently the Ministry of Finance is the relevant authority over the SEC but they usually do not interfere. Only when the market crashed, MOF actually came in.

    But even if we have a govt institution they will face the same problem. The thing is that the influential people who are calling the shots in the capital market ensure that the other influential people (regulators, politicians, intelligence) get a due share of the money.

    Rating agencies are present (4 of them). But unfortunately some of them have similar allegations of giving favorable ratings for money.

    Bangladesh is a pretty new country in terms of age and presently due to consistent economic growth people are accumulating wealth at a pretty fast pace. This is probably why so many people have no respect for laws and ethics. Maybe things will improve as time passes.

  3. Well we can only hope that someday people of High Moral Ethics & Integrity can stand up against widespread corruption and restore public faith in the markets & Gov’t. Although Bangladesh’s economy is growing at a healthy pace, the biggest obstacle to double digit annual growth is Governmental corruption, I am sure you can agree with me on that.

    – Shezan

  4. Undoubtedly. When people at the top break all rules everybody else takes a cue. That is why the same Bangladesh flouting all laws in Bangladesh goes abroad and becomes a model citizen. I do not expect saintly politicians but there has to be a dividing line where the politicians cannot compromise.

    If there is a political will everything is possible. We just need to look at Turkey which transformed itself in around 9 years.

    Asif

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