By David Sterman
If you're a regular reader, you probably know about the $1.7 trillion "Dividend Vault." Simply put, that's the name we've given to the unprecedented amount of cash that U.S. companies have stockpiled in the aftermath of the Great Recession.
And for months now, we've been saying that this is great news for investors.
That's because we're predicting that a large chunk of that $1.7 trillion will go toward two things: dividends and stock buybacks. I won't spend a lot of time talking about what the "Dividend Vault" means for dividends today (if you're interested, you can read our past coverage of this here, here and here).
Instead, I'm going to talk about the other side of the coin -- stock buybacks, namely, what they can do for investors, including a group of stocks I've got my eye on that are buying back shares at a furious pace.
Buybacks in a bull market
For as long as companies have been buying back stocks, investors have questioned the wisdom of such moves. After all, a number of companies have completed massive buyback programs in bull markets, only to find that shares could have been bought at much lower prices once the market slumped in value.
That concern has been in the headlines again, as newly-announced buyback activity remains quite robust, even as the market makes an impressive spurt toward new highs. To test the wisdom of the current buybacks, I looked at the data. [Roughly four months ago, I looked at stocks embarking on big buyback plans.]
All of the companies, with the exception of IBM (NYSE: IBM), had plans to eliminate more than 10% of their shares outstanding, and the market has surely responded. The average gain for this group since Nov. 5, 2012, is roughly 19.5% -- or nearly twice the gain of the surging S&P 500.
From bankruptcy to flush in just five years
On the list above, you'll notice two stocks from the same highly cyclical auto parts industry: Dana Holding (NYSE: DAN) and TRW (NYSE: TRW). These firms, along with most of their rivals, appeared to be in deep financial distress when auto sales plunged in 2008 and 2009. Just a few short years later, they are the picture of health and have such fast-rising cash balances that ongoing major share buyback programs likely will be the norm. (Each of the five auto parts suppliers discussed in this column announced buyback plans in 2012.)
Brett Hoselton, who follows the industry for KeyCorp (NYSE: KEY), noted that "the combination of under-levered balance sheets and strong free cash flow generation has left many auto suppliers with substantial capital (i.e. billions of dollars) that can be deployed in the form of accretive acquisitions, dividends or share repurchases," adding that "auto suppliers are clearly becoming more aggressive in their deployment of capital to shareholders, particularly share repurchases."
Hoselton estimates that TRW, Dana, Borg-Warner (NYSE: BWA), Magna (NYSE: MGA) and Lear (NYSE: LEA) might seek to retire 20%-40% of all of their available stock through share repurchases. Looking simply at his price targets relative to current prices, Hoselton said TRW appears to offer the greatest upside, with 35% potential appreciation toward his $80 price target.
I prefer to see stock buybacks when a company is trading below tangible book value, as the math of buybacks becomes especially compelling at that point. Unfortunately, Dana, Magna and Lear trade for nearly two times tangible book value, while TRW and Borg-Warner trade for more than four times book value.
In the context of price-to-earnings (P/E) ratios, massive buybacks make more sense. Most of these stocks trade for less than 10 times projected 2014 profits, and industry analysts think that sales of autos (and auto parts) will be even higher in 2015 and 2016 as the global industry gets back on its feet.
As an added kicker, these profit forecasts account only for share buyback plans already announced and not the ones still to come.
Risks to Consider: As noted, share buybacks can come at the top of the market, which would, in hindsight, made these actions look ill-timed.
The charm of share buyback plans is that they provide downside support if the market takes a tumble. Companies in the market for their own shares tend to offset any external selling pressure in place. And any market pullback -- if it does affect these stocks -- means these companies can acquire more shares for the same amount of money.
With regard to the stocks I mention in this article, KeyCorp's Hoselton says "There is as much as 10% to 40% potential upside to earnings estimates should auto suppliers choose to aggressively repurchase shares." Lear, Dana and Magna are most capable of buying back nearly 40% of their share count, according to Hoselton, while TRW and Borg-Warner could buy back a more modest 20% to 25% of their share count. I agree with this analysis, and think any of these stocks could provide solid support in a downturn, with possible ample upside potential.