What is a share buyback?

Q: What is a share buyback?

Scottish Mortgage, Britain’s largest investment trust, surprised investors two weeks ago when it announced that it would spend at least £1bn on buying its own shares.

Investment trusts, and indeed ordinary listed companies, regularly announce these “share buybacks” and, while they are often welcomed by professional investors, ordinary savers may be left wondering how they benefit – if it all.

So it’s worthwhile explaining how buybacks work and what they are intended to achieve.

What happens in a share buyback?

Anyone can buy shares in a listed company, including the company itself, although normally it must first seek permission from shareholders.

Just like any other buyer, a trust will ask its stockbroker to buy the number of shares it wants and will often put a maximum on the price it is prepared to pay. The broker then looks around the market and seeks to follows the trust’s instructions.

Once the shares have been bought, the trust can do two things with them: it can cancel them or it can hold on to them with a view to selling them later. If it does the latter it is said to hold them “in treasury”.

What are the advantages of a share buyback?

Does that all sound strange or pointless? Buybacks certainly have their critics but in certain circumstances there is a logic to them.

The most important of those circumstances is the prevailing share price. In particular, there is a strong case for buying back a trust’s shares if the share price is appreciably less than the net asset value per share.

Just like any other buyer, an investment trust that buys its own shares when they are trading at less than their net asset value is getting assets for less than they are worth. This has the effect of making the trust more valuable on a per-share basis.

If that sounds a bit abstract, let’s work through an example. For clarity’s sake we’ll look at a highly simplified imaginary investment trust called Alpha, whose only assets are 100 shares in a company called Zeta. There are 100 shares in the trust in circulation. Again for simplicity, we’ll assume that the market value of Zeta shares does not change but remains at 100p over the course of the buyback.

We’ll also assume that the trust is trading at a discount of 50% (while this may sound extreme, there are in fact several that currently trade at even wider discounts!). As the trust’s assets are worth £100 (100 shares in Zeta at 100p) and there are 100 shares in the trust, its net asset value per share is 100p. As we have assumed that it’s trading at a 50% discount to net asset value, its share price is 50p.

The trust decides to spend 10% of its assets on buying back its shares. So it sells 10% of its shares in Zeta and thereby raises £10. It then spends this money on buying its own shares. As they are trading at 50p, that £10 buys 20 of them. It cancels the shares it has bought back, so that now there are only 80 shares in the trust in existence (although holding them in treasury would have the same effect). As its net assets have fallen by 10% they are now £90. To work out the net asset value per share we divide that £90 by the number of shares in the trust, 80, to arrive at 112.5p. Remember that before the buyback the net asset value was 100p per share, so the transaction has increased it by 12.5%.

If the discount remains at 50%, the share price will rise to 60.25p (112.5/2), which is also a 12.5% increase. While we can never be sure what will happen to the share price, which is always at the mercy of market forces, we can see that, as a certain consequence of the mathematics, a trust’s net asset value per share will rise if it buys back its own shares at a discount.    

In practice, the share price will often rise by more than the increase in net asset value per share because the trust is a new buyer in the market and is creating extra demand. In fact the share price will often rise as soon as plans for a buyback are announced. This is what happened to Scottish Mortgage shares in March.

Another advantage of buybacks is that, if they are conducted in conjunction with a policy to issue shares when the share price is at a premium, the trust has a “discount control mechanism” that should maintain the share price at around net asset value. In other words, there should never be either a premium or discount of more than a couple of per cent. This can encourage some investors to put money in the trust who might otherwise be put off by the fact that discounts and premiums add an extra layer of uncertainty to their returns. Several trusts have managed to do away with significant discounts or premiums for many years thanks to their discount control mechanisms.

What are the disadvantages of a share buyback?

The first drawback is that the trust shrinks: money flows out of the fund and it gets nothing of value in return (the shares it buys back are either cancelled or held in treasury, where they are deemed to be worthless until resold). When a trust shrinks, it may become less attractive to certain buyers; for instance, it is a rule of thumb that an investment trust worth less than £200m will not be considered by wealth managers.

When a trust shrinks, many of its costs will remain the same. As a result, its percentage annual charge is very likely to increase.

A trust that repeatedly conducts large buybacks in an attempt to control its discount could even end up so small as not to be viable.

Where does an investment trust get the money to buy back its shares?

It has a number of options.

Sometimes a trust will have some cash, which it could simply use to buy its shares. Otherwise it could borrow the money: trusts frequently have credit lines arranged with banks so that they can respond quickly if they want to buy more assets or buy back their own shares.

Finally the trust could sell some of its assets to raise the money to buy back shares.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.