After seeking shareholder permission, companies that find themselves over capitalized can buy back some of their shares in the marketplace. Like directors dealings, these buybacks must be suspended during the closed period of two months leading up to their results. This can provide an opportunity for traders to take advantage of. For example by establishing a short position just as the buy-back is finishing, closing the short during the anticipated share weakness leading up to the results and perhaps establishing a long position in readiness for renewed share price support when the buyback recommences.
Now not all buybacks are done for the same reason, so it pays to research the companys position and possible purpose in trying this ploy before assuming that the standard stock variations will apply. For instance, recently companies have had a surplus of cash caused by government rescues, and a buyback is an unimaginative way in which they can use the funds. The purchase should result in a temporary increase in value of the shares, but bear in mind that the longer term prospects may not be so good if the best use that the company has for the money is buying back their own shares, and they do not spend the money on acquisitions or research and development.
Some companies seem to have their priorities wrong in the use they make of their funds. For instance, General Motors have spent more than $20 billion on buybacks since 1986, and if they had instead invested the funds they would have had $35 billion more in cash at the time they were declared bankrupt and taken over by the US Government. Eight of the banks receiving bailout funds from the US Government had spent nearly $200 billion on share buyback schemes before they found themselves in trouble. So a buyback is not always a wise decision on the part of the companys management.
Sometimes companies back themselves into a corner and almost have to start buyback schemes because of the employee benefit programs that they have. Employee Stock Ownership Programs (ESOPs) give workers rights to own shares, and if too many shares are issued they suffer from dilution, and devalue the stock. The answer to this is a buyback scheme, but this needs to be done to bolster the stock values regardless of other considerations. Cisco and Dell Computer are examples of this way of thinking.
When a company buys back shares, it reduces the number of shares outstanding, which increases the size of dividends for the remaining stockholders. CEOs are often judged by the perceived profitability, for which one of the metrics is the size of dividend, and from such judgments come the bonus payments, thus it is in the managements personal interest to take steps to reduce the number of publically owned shares.
In general, buybacks can be used to try and change the markets perception of the company. One way of implementing a buyback is to offer to buy shares from existing shareholders, and this is usually at a higher than market price in order to tempt them to sell. So the shares become perceived as being of a higher value. Apart from reducing the dilution of the number of shares, and increasing dividends, this is a way in which companies can set their own share values for investors to consider.
In summary, many opportunities can present themselves to the lazy trader simply by following the actions of established shrewd investors such as Jack Petchey, Peter Webb, Jon Moulton or Bob Morton. These individuals have a good reputation for accumulating stakes in undervalued companies and acting as a catalyst for extracting shareholder value.