In praise of share buybacks

David Prosser explores how boards are turning to share buybacks to address wide discounts.

Listing image

Investment company directors have been busy. Research from market analyst Winterflood reveals that investment companies have bought £2.2bn worth of their own shares so far this year – that’s 53% more than they had purchased by this time a year ago. So what’s going on?

The answer is that investment company directors are trying to get discounts under control. Sometimes, demand for investment company shares on the stock market gets out of sync with the value of the fund’s investments. In which case, the fund’s share price may start trading at a discount to the value of its underlying assets. This year, with stock market sentiment undermined by economic uncertainty, many investment companies have slipped to unusually wide discounts – in many cases, share prices undervalue their assets by double-digit margins.

Buybacks are a possible solution to the challenge of wide discounts. The investment company is effectively aiming to rebalance demand and supply by reducing the number of its shares available. If it is hard to influence investor demand, directors can at least take action on the other side of the equation.

"If it is hard to influence investor demand, directors can at least take action on the other side of the equation."

David Prosser


It should be said that buybacks are not a silver bullet. Indeed, despite the best efforts of many funds, discounts remain stubbornly high – the average investment company currently trades on a discount of almost 15% to the value of its underlying assets, with little evidence of any narrowing trend.

Partly, this reflects broader market sentiment. When investors are in risk-averse mode to the extent they have been this year, it just isn’t possible to turn the tide with buybacks alone. You also need a change of mood.

Nevertheless, the evidence of history is that buybacks can help investment companies manage their discounts. Over the past two decades, the sector has generally traded on much narrower discounts than in times gone by, partly because directors have become much more interventionist in this regard. And in simple terms, the positive effect is obvious: by definition, reducing the number of shares in an investment company means each remaining share gets a greater share of overall income and capital gains.

There are costs to consider too, of course. Running an investment company carries a number of fixed costs, which will now need to be shared out across a smaller number of shares. Plus, there are transaction fees incurred during the buyback process itself. A related issue is that if an investment company has gearing in place – borrowing for investment – debt per share will also rise following a buyback.

Still, buybacks can help investment companies move towards an improved valuation – and to do so more quickly as broader market sentiment picks up. If nothing else, they represent a signal of intent from the fund’s board that the directors are prepared to confront this issue.

Indeed, a growing number of investment companies now operate with mandatory discount control mechanisms. These require the directors to intervene with policies such as buybacks in the event that the fund’s discount hits a certain level.

It’s worth pointing out that discounts, in themselves, are not necessarily a bad thing. Apart from anything else, they provide new investors with an incentive to put their money into the fund. And they’re really just a reflection of the structure of an investment company, which brings certain advantages too.

Still, investors understandably feel uncomfortable with persistently high discounts at funds where they hold shares; they don’t want the realisable value of their holdings to be undervalued in this way. The growing volume of buybacks this year is therefore to be welcomed.