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Make money during a buyback

Tinesh Bhasin in Mumbai | February 02, 2009 15:41 IST

Amid a bearish stock market and falling valuations, 23 companies are currently planning to buyback a portion of their shares from investors. These companies are collectively buying back shares worth Rs 3,355.11 crore (Rs 33.55 billion). This includes big names such as DLF, Godrej [Get Quote] Consumer, Bosch and Reliance [Get Quote] Infrastructure.

The sound of buyback could be pleasing for many investors, as companies usually pay a premium to the market price of the stock. And many traders take this as an opportunity to make money.

A market-savvy investor can also use this opportunity to make a quick buck. That is, purchase the share at a lower price from the market and sell it back to the company at a higher price. Though this is not a long-term strategy, one can use some part of the trading portfolio to take advantage of the arbitrage opportunity.

A company buys back its shares for various reasons. It helps boost investor sentiment and reflect the management's confidence. In the current market conditions, it also sends a message to investors that the company is not cash-strapped.

But the most prominent is the company's valuation. "Promoters announce buybacks when they believe that the share price does not reflect the intrinsic strength and growth potential," said Daljeet S Kohli, head of research with Emkay, a share broking company. A share buy-back increases the earnings per share of the company, which may in turn impacts the stock price positively.

There are two ways for a company to buy shares. They can purchase it in the open market. In the second case, they take the stock directly from shareholders called as tender offer. In open market purchase, the company gives a ceiling price. It cannot transact, if the shares cross the specified ceiling price. These shares can be bought over a long period. In some cases, it is over a year.

In tender offer, shareholders are given a fixed price. The shareholder needs to sell the stock to the company within a 15-day specified period. "There is an arbitrage opportunity when a company pursues the tender process of buyback," said Arun Kejriwal, an investment adviser and director, Kejriwal Research and Investment Services.

To understand how arbitrage works in tender offers, let's take an example of Abbott India [Get Quote]. Last year, the company had bought back 3.8 per cent of its total shares at Rs 630.

When the buyback was announced on July 11, the share price was Rs 550.15. Let's assume an investor bought 100 shares of this company and sent it to the company under the tender offer. Since Abbott had received four times the shares it had sought, it would have bought 25 shares out of the 100 sent. The investor would have made a profit of Rs 1,196.25 on the 25 shares.

The investor makes 14.51 per cent on the 25 shares in less than a month. And on the total money invested, he would have made 3.54 per cent. He is still in possession of 75 shares that he can dispose of at a future date.

In such offer, investors have the potential to earn high in three circumstances. The obvious one is the differential in the market price and buyback price on the date of announcement. The returns will also rise, if the issue subscription is low. The arbitrage can also work better when the number of shares that the company is purchasing is high.

However, it is important to remember that such opportunities are not available in an open market offer because the time period is longer and purchases can be made any time by the company.

As far as taxation goes, since there is no securities transaction tax because the shares are bought by the company directly. Hence, the profit is come under the head of 'income from other sources.' The person pays tax on the profit based on his income slab.

Buybacks do offer arbitrage opportunities but it also comes along with the risk associated with the equities market. When a person receives the excess shares, he has to take a call on whether to sell them immediately or hold them for future gains. Also, one should avoid borrowing to take advantage of such offers because there is an uncertainty on how many shares would be purchased by the company.

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