Share buybacks – what are they and what do they mean for your investments?

Investment Trusts have had a tough time of late, meaning that they now look cheaper than at any time since the 2003 financial crisis prompted by the invasion of Iraq.1

But the companies’ chiefs are fighting back, using one of the few vehicles at their disposal to push up prices and reduce the widening disparity between the trust’s share prices and the value of their underlying assets.

Recent figures from broker Winterflood suggested that the use of share buybacks – where an investment trust buys its own shares– was up 53% in the first half of the year.2

But is a share buyback programme a guarantee that your investment will rise in value, and what does it mean for the sector as a whole? The following answers could help.

What is a share buyback?

Share buybacks are not just used by investment trusts, but by other listed companies too.

When a company announces a buyback, it uses the cash on its balance sheet to buy its own shares on the stock market at their current trading price. In most cases, it will then cancel the shares so that there are fewer shares in issue; however, the shares can be held by the company in a different form to be reissued later.

Why might a company buy back shares?

Share buybacks are billed as a way of returning money to shareholders. The theory is that by repurchasing shares, the remaining shares will rise in value. Existing shareholders will own a higher percentage of the company and will be entitled to a greater share of any profits in future.

Why are share buybacks so popular with investment trusts?

An investment trust is a fund consisting of different investments that is itself listed on the stock market. The share price moves up and down during trading, but the value can be higher or lower than the most recent valuation of the investments that are held by the trust.

At the moment, most trusts trade on a discount to this valuation, known as the Net Asset Value or NAV, with the average being around 15%.3 Buying back the shares can help this discount to narrow, as the share price is likely to rise.

Shareholders who want to sell up are particularly helped by these discounts, as they may not be able to hold on to see if the share price recovers naturally to what the shares are ‘worth’.

Do share buybacks always work?

Share buybacks will always reduce the number of shares in issue, but the share price only rises if the demand for shares is there. If everything else remains equal, and investor sentiment stays the same, a share buyback should therefore increase the share price.

If sentiment dips at the same time as the buyback, the share price may still fall.

Why don’t investment trusts just pay a dividend instead?

Instead of buying back shares, a company could simply choose to return the cash to investors in the form of a dividend. There are several reasons why they might choose a buyback.

They may think the shares are undervalued now, so can pick up a ‘bargain’ of sorts, or they may not want to set a precedent by paying a higher dividend that they may not be able to maintain.

Buybacks also offer an advantage to some investors, if they would usually invest the dividends they receive into new shares. With a buyback, the company effectively does this for you, so you do not pay transaction charges.

Is a share buyback a good sign for investors?

A share buyback may be a sign that the price of a stock is about to rise. It may also be a sign that the management thinks the shares are currently good value, and that they are committed to doing something about the discount to NAV in the case of an investment trust.

However, there is no guarantee, so it’s important that you also look at the underlying investments in a trust and the skill of the management before deciding to invest.

This article discusses a type of investment in broad terms and does not constitute financial advice. Please consult with your financial adviser to discuss your individual objectives, circumstances, and risk appetite before considering investing.

Friday 15 December 2023