Buyback bonanza

Cherry Reynard analyses the buyback boom.

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In March, Scottish Mortgage Investment Trust announced a £1 billion share buyback programme, designed to narrow its persistent discount to net asset value. At a time when investment trust discounts are wide relative to history and arbitrageurs are hovering over the sector, it is one of a number of trusts that have decided to buy back shares. But will it make a long-term difference to share prices?

The Scottish Mortgage programme will take place over two years and tops up the £350 million in buybacks it has done since 2021. Markets have greeted the news warmly, with the share price rallying 11% since the announcement. The programme is equivalent to around 8% of its net assets. This is high, but others are even higher. Pantheon International, for example, committed 14% of its market capitalisation to buybacks in the financial year to 31 May 2024. 

What are buybacks?

Share buybacks are where an investment trust repurchases its own stock, reducing the total number of shares outstanding. The trust will need to finance these repurchases through selling its underlying assets, or by through any income generated. Trusts undertake buybacks with the aim of creating more demand for their shares, usually in response to persistently high discounts. This should have the effect of reducing the discount and lowering its volatility. It is also a signal to the market that the trust’s board has confidence in the trust’s investment strategy and believes the shares to be undervalued. 

“Trusts undertake buybacks with the aim of creating more demand for their shares, usually in response to persistently high discounts. This should have the effect of reducing the discount and lowering its volatility.”

Cherry Reynard

Cherry Reynard

A bigger question is whether it works. The answer is not totally straightforward. Matthew Read, senior analyst at QuotedData, says: “Discounts expand when there is an excess supply of shares in the market relative to demand. Buybacks help mop up some of that excess supply. That said, the long-term effectiveness of buybacks really depends on the factors creating that excess supply in the first place. If there is some form of structural issue, perhaps an inappropriate fee structure or a poorly performing manager, no amount of buybacks are likely to stem the flow of investors wishing to exit. Boards need to address these issues first.”

He says buybacks are best employed to deal with a modest imbalance of supply and demand in the normal course of trading. “Alliance Trust, for example, regularly buys back shares when its discount is above 5% and has been very successful at keeping its discount around this level,” he adds.

Nick Greenwood, manager of the MIGO Opportunities Trust, says trusts also need to ensure they buy back the ‘right’ amount. He adds: “If there is excess supply of 10 million shares and the trust only buys back 9 million, there won’t be an effect on the share price. The board has to have a view on what the over-supply situation is. For this, they need to read the market correctly.”

He says that there can also be difficulties if only one trust in a specific sector undertakes buybacks. For example, if there are a number of private equity trusts trading at a 40% discount and one does buybacks, reducing the discount to 20%, investors may sell their shares back to the company and move into another trust still on a 40% discount. Trust boards need to be nuanced in the way they apply buybacks.

Risks to buybacks

There are risks to buying back stock. Read says: “If a fund is small, undertaking share repurchases and shrinking it further, and possibly making it subscale, is probably not in shareholders’ interests.” Consolidation in the wealth management market has meant that this part of the market finds it increasingly difficult to buy small trusts. If a trust gets too small, it may deter certain buyers - exactly the opposite effect to that intended. 
There may also be other, potentially cheaper, alternatives to buying back stock. Boards could increase marketing, improve the fee structure, or put in place regular continuation votes. If a large group of shareholders want to exit, Read says a tender offer may be a better option. “Often a combined approach is required. There is no unique solution and what a board opts for will depend on the fund’s structure and the particular challenges it faces.”