The S&P 500 companies have been buying back their stock at rates not seen since the now onerous year of 2007. Buybacks generally occur when companies have cash on hand exceeding what they need to operate the business and/or invest in future growth.
In the past, when companies had excess cash it usually came back to investors in the form of a dividend. While many companies still pay dividends, a buyback is a more tax friendly way to return capital to shareholders. When dividends are paid, tax is owed. When a buyback occurs, fewer shares outstanding means higher earnings per share, which may cause the price of stocks to rise while increasing investors wealth and deferring taxes.
Buybacks have really caught on as the S&P Dow Jones Indices most recently released figures demonstrate.
- For fiscal year 2014, S&P 500 issuers increased their buyback expenditures by 16.3% to $553.3 billion from $475.6 billion posted in 2013.
- The high mark was reached in 2007, when companies spent $589.1 billion.
- Share count reduction significantly increased earnings-per-share (EPS) for 20% of the index issues in each of the past four quarters. For the fourth quarter, the number of issues reducing their share count by at least 4% year-over-year, and therefore increasing their EPS by at least that amount, continues to be in the 20% area – a significant level.
Academically Speaking
Dividends are the stuff of endless fascination for academics and economists. In the early sixties, Nobel prize winning economists Merton Miller and Franco Modigliani concluded dividend policy was irrelevant to company valuation. From the logic of the paper, it would follow Miller and Modigliani would also likely conclude buy backs are irrelevant to a stock’s value, a perplexing idea given the amount of cash boards of directors allocate to dividends and buybacks.
Since then, there has been some important research on the impact of share buy backs. In particular, Ikenberry, Lakonishok and Vermaelan’s 1995 paper, Market Underreaction To Open Market Share Repurchases, demonstrates that over time companies that buyback their own shares do tend to outperform the market as a whole.
Whenever we see a deviation from market efficiency however, we are constrained to ask why. We feel the answer lies in what buybacks say about a senior management team. Instead of using excess capital on value destroying acquisitions, management teams who chose buybacks to distribute wealth have achieved their goals in a rapid and tax efficient manner.
Further, management has insider information about a company and is likely to know if the company is over or under valued. And finally, because management often owns a lot of stock, but can’t trade on what they know, a buyback may be a management team’s best way to profit from the knowledge they do have. After all, it’s hard to imagine smart managers buying shares back when they thought the stock was over valued.
Don’t Try This At Home Folks
While institutional investors might achieve alpha using buyback data, individual investors likely won’t because of the degree of difficulty and possible fees involved.
In terms of difficulty, last week’s or last quarter’s buybacks don’t really shed all that much light on next quarter’s. For instance, who knew, that Apple, the most closely observed company on the planet, reduced its’ buyback in the last quarter of 2015 to just $5 billion, from $17 billion in the third quarter? And what does that tell us about buybacks next quarter?
For individual investors, buyback information must be used as single factor in constructing a total portfolio, and not as a tool for speculation. Better, in our view, to work with firms that that can place your investments with institutional managers who bring knowledge of the buyback anomaly to the table and can help you benefit from the growing volume of wealth distributed through buybacks.
