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Should you participate in a share buy-back?

12122018_share buy backs

Should you participate in a share buy-back?

The Federal Labor Party has stated it would change the dividend imputation system if returned to power in 2019.  This is expected to see a spike in the number of off-market share buy-backs.  The big question for investors is: should you participate?

Labor’s policy would see a scrapping of cash refunds of franking credits for most investors with low or zero taxable income. The deadline for excess franking credits to be paid as cash refunds to low-taxed investors is expected to be June 30.

Ahead of this potential change of government, there is an expectation from the investing community that there will be a spike in off-market share buy-backs and special dividends as companies seek to take advantage of existing arrangements to distribute excess franking credits sitting on their balance sheets. These companies should have historically generated large domestic profits and have surplus capital so as to not compromise the balance sheet when the capital is returned.  The larger miners (BHP and RIO) have already returned capital following their asset divestments, and Woolworths and Caltex are mooted as potential candidates.

For domestic investors, the decision to participate in an off-market buy-back will depend on a number of factors. The most significant will be the investor’s marginal tax rate and the buy-back price. Put simply, the benefit of an off-market buy-back to investors is the value of the franking credits associated with the buy-back; this is because the tender price is split into a franked dividend component and a capital component of which the dividend is a significant percentage of the final price.

For example, in Rio Tinto’s recent A$2,871 million buy-back, the fully-franked dividend component of the final buy-back price of $69.69 per share was $60.25 per share, while the capital component was $9.44 per share. In this example, the value of the franking credits associated with the dividend is $25.82 per share – a potential cash refund for those with low marginal tax rates. In addition, depending on the cost base of your Rio Tinto shares, the $9.44 per share capital component may lead to capital losses which may be utilised to offset capital gains.

Rio Tinto’s tender booklet explains the mechanics of an off-market buy-back to an investor on page 15.

It is important to remember most off-market buy-backs are conducted at a significant discount to the prevailing share price, while also being subjected to scale-backs depending on the level of demand. This is because of the beneficial economics for domestic superannuation investors (taxed at 15 per cent) which leads to high levels of participation from many large institutional investors.

Each investor should assess their own particular tax situation to determine the relative economics of the buy-back although the general rule is those with a lower marginal tax rate (15 per cent or lower) are the biggest beneficiaries.

Click here to read RIO’s tender booklet

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Joseph is a Senior Analyst at Montgomery Investment Management. Joseph has twelve years’ experience in equities research, funds management and M&A. Before joining Montgomery, he was a Senior Analyst at Colonial First State Global Asset Management responsible for coverage of resources, energy, infrastructure and industrials sectors. Joseph’s prior experience includes roles in equities research at JP Morgan and at Ellerston Capital.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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4 Comments

  1. Roger, what are your thoughts on NDQ. They appear to have a high ROI, a low P/E – and gives an AUSSIE investor some exposure to large well credentialed overseas companies.. But what is your expert opinion..thanks in anticipation..

  2. But if you sell back your shares then you won’t get dividends or capital growth from the shares you no longer own. It makes no sense to me unless you want to sell your shares anyway. As a long term investor, forget it.

    • Hi Carlos
      With the buy-back, you can tender your shares to obtain the benefit from the franking credits and any capital losses that may arise from participating in the buy-back, and then re-buy back the shares you sold.
      You are exposed to a small amount of market pricing risk as the buy-back is usually conducted on a 5-day Volume Average Weighted Price basis (VWAP), and you will be buying back on a specific day where the price may be different to the VWAP. Usually the difference is not significant enough to change the outcome materially.

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