A head fake in basketball gets your opponent to jump in the air when you feign a shot.
Likewise, a head fake in the capital markets gets an executive’s stock price to jump for no reason. Consider a situation where executives are lamenting that their company’s shares are worth more than the bid price. If this continues, they might look for ways to raise the price. Here are some methods.
Substantial issuer bids
Sometimes, companies announce unexpected share buybacks. These are called substantial issuer bids (SIBs), in contrast to normal course issuer bids, which are annual renewals of a standing buyback. SIBs can take the market by surprise and lift the stock price. Whether those gains hold over time is another matter.
In March 2016, Home Capital Group announced an SIB to repurchase $150 million of its shares through a Dutch auction, where investors specify the number of shares they wish to sell and the price they’ll accept in return. Once all offers are in, the company determines the average price required to spend the cash allocated for the deal. Everyone receives the same price, with some shareholders receiving more than they expected, but no one receives less.
Home Capital offered to buy back shares for $34 to $38—a price range that equated to 6.3% to 5.6% of total shares outstanding, respectively. The offer was good for five weeks and eventually settled at $37.60 per share (representing 5.7% of shares outstanding).
The manoeuvre worked as hoped; or it did, at least temporarily. Shares jumped 5% on the announcement and, in the days after closing, reached their highest level since the company announced it had terminated several mortgage broker relationships due to loan documentation fraud.
The downside of purchasing so many shares at the same time is that it goes against dollar cost averaging, which we addressed in “Buybacks vs. dividends: Which is better?” (AER February 2015). The risk is that the stock can drop significantly in the months afterward, which costs the remaining shareholders.
Had Home Capital spread the $150-million purchase over 12 months, it could have bought shares at an average 22% discount to what it paid, and picked up an additional 1.1 million shares.
In fairness, not all SIBs are aimed at boosting share price. In a minority of cases, we’ve seen the process work well to distribute excess capital to shareholders.
Occasionally, a company launches a strategic review to help with what management perceives as a languishing share price.
In July 2016, Northland Power Inc. (NPI) announced in a press release that its board of directors had commenced a review of strategic alternatives to “enhance growth and shareholder value”—generally taken as code for a company putting itself up for sale, especially when there is a major controlling shareholder, as is the case with Northland.
The release did the trick, and the share price jumped 7% that day. Further, four analysts who cover the company raised their target prices as a result of the announcement. Over the course of the next year’s conference calls, analysts asked the company for review updates but management declined comment, stretching out the resolution.
Not to be dissuaded, analysts kept the review warm in their research reports, with one in particular repeatedly stating that “the strategic review is the most significant potential catalyst for the stock in the short term.”
In July 2017, Bloomberg published a report citing those familiar with the situation who stated that the company had failed to find a buyer, with some Canadian pension funds balking at Northland’s valuation.
Despite the news leaking into the market, Northland waited more than a month—until it had released Q2 results—to officially kill the idea of selling. That behaviour was quite different from when it announced the review with a special intra-quarter press release in the first place.
Of the analysts who had initially raised their target prices, none subsequently lowered their outlook after the strategic review yielded nothing of value.
No one highlighted the seeming contradiction: despite numerous institutional investors finding the company’s valuation too expensive, many analyst target prices implied significant upside return. In fact, some analysts turned the situation around, with one writing that “most will be pleased the review is over and the focus returns to NPI’s fundamentals.” There’s nothing like a lead left underwriter when it comes to seeing the bright side.
Don’t fall for head fakes on the court or in portfolios
Never invest solely on the idea that a strategic review will result in a company sale or similar positive outcome.
Even when legitimate, such reviews can languish for more than a year with nothing to show in the end, as better investment opportunities pass by.
Similarly, investors should be wary of executives who launch SIBs seemingly out of nowhere, with no clear need to return excess capital.
These bids can backfire or provide only temporary benefit. Often, the winners are those who drop the stock when a premium is offered for no apparent reason.