The big buyback
David Prosser on why investment companies buy back their own shares.
For investment company boards worried that their fund’s share price substantially undervalues its assets, share buybacks are often the go-to strategy. So it is that buybacks continue at pace: with discounts rising across the sector, investment companies bought £2.8bn worth of their own shares during the first nine months of the year according to data from Morningstar and Winterflood. That was a 34% increase compared to the same period of 2022.
The principle of share buybacks is straightforward. When an investment company’s shares trade at a discount to the value of its underlying assets, it essentially means there is an imbalance between demand and supply for the stock. Reduce the supply, therefore, and you should begin to address that problem. It also helps that with fewer shares with a claim to the fund’s profits and income, each share looks more attractive, supporting demand.
“When an investment company’s shares trade at a discount to the value of its underlying assets, it essentially means there is an imbalance between demand and supply for the stock. Reduce the supply, therefore, and you should begin to address that problem.”
This is why many investment companies now have a discount control mechanism – a process through which buybacks are automatically triggered if the discount hits a certain level. Other approaches are not quite so rigid, but their boards will nonetheless consider intervening if the discount becomes concerning.
Of course, buyback programmes don’t necessarily deliver instant results. Despite the huge investments made in their own stock this year, investment companies have seen discounts continue to widen – to a post-2008 high at the end of October The reality is that when demand for investment companies is particularly depressed – and the past year has seen a retreat from a range of “risk-on” assets – shifting the market dynamic is very difficult.
Also, investors should know that buybacks come with certain downsides. They reduce the overall size of the fund, which may limit its viability over time, since investors – particularly institutions and those running larger pools of money – want to hold funds where there is plenty of liquidity.
Additionally, investment companies carry certain fixed costs, which must be shouldered by fewer shares following a buyback. Similarly, if the trust has gearing in place, this borrowing will increase in per share terms. And the buyback process itself will involve certain transaction costs.
Nevertheless, buybacks are important. They send a powerful signal that the investment company’s board is alert to the frustrations of investors. Investment company managers aren’t always keen, because the fees they earn often depend on the total value of the fund, so boards’ willingness to focus on the interests of shareholders is welcome.
The other point is that a buyback gives investors an opportunity to exit the fund at a price that offers a much better reflection of the assets they’re selling. Boards hope investors will stick with them, but for those ready to move on, this is an opportunity to do so at a fairer price.
The academic evidence on share buybacks is quite mixed. Some studies have suggested they can have a profound effect in the short term, but that investment company share prices tend to revert to reflect market sentiment over time. Still, that’s not necessarily a bad thing – the goal is often to get the fund past a short-term issue, in the hope that the market will in time come to view it through a more positive lens.
On that front, watch this space. Investors hope that as equity markets begin to show greater strength – and as the interest rate cycle supports other assets – investment company discounts will start to narrow naturally. There have been some signs of such green shoots in recent weeks. In the meantime, however, we can expect more buybacks over the rest of the year.