Don't Follow Me, I'm Lost: Stock Buybacks

Includes: AAPL, HD, MRK, T, XOM
by: YCharts

By Suzanne McGee

In any market environment, it helps to know who is doing the buying. That is particularly true of a bull market we're experiencing today, as the S&P 500 index steams northward towards 1700 even as corporate profits grow at a more meager rate and revenues disappoint. As Jeff Kleintop, chief market strategist at LPL Financial, summarized the state of buying and selling in the midst of the rally, while hedge funds, institutional investors and insiders aren't buying, and foreign demand for U.S. equities is dwindling, the only two sources of demand for stocks are individual investors and companies themselves.

Corporate stock buybacks are on the rise, for reasons that have as much or more to do with the market's gains than they do with the conviction among corporate executives that their stocks are undervalued. As prices rise, employees who have received grants of options are more likely to find those are in the money and to exercise those options, raising the number of shares outstanding and diluting earnings per share. "When prices rise, companies act to offset dilution by following through on buybacks," says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

In other words, companies are compelled to buy their own shares when the stock is expensive, and have less of a reason to be buyers when the shares are down. Hmmm. Something's horribly wrong here. For individual investors, aping this behavior seems unwise. Companies could, of course, pile up cash and buy back their own shares aggressively after a market correction, but that would take a long-term view often lacking in financial management.

When Silverblatt released his review of fourth-quarter buyback activity in late March, he predicted that companies would "become slightly more aggressive" in their buyback activity in order to keep ahead of dilution - and that is what seems to be taking place. According to data from Birinyi Associates, April was the strongest month it had recorded in buybacks, thanks to Apple's (NASDAQ:AAPL) $50 billion repurchase authorization. During the first four months of 2013, a period when the S&P climbed 12.02%, the number of buyback announcements rose 26%, marking the strongest start to the year recorded by Birinyi.

The combination of the headlines about Apple's big buyback authorization, and the likely chatter about how buybacks can help fuel a rally in the kind of environment we're in today, characterized by thin trading volume, make it all the more important to hone in on stocks whose buybacks aren't just announced but completed, and that result in a real reduction in the number of shares outstanding. Moreover, notes Silverblatt, those companies shouldn't be buying back shares to mask what would otherwise show up as a decline in earnings per share. In other words, you're looking for a stock like DirecTV (DTV).

DTV Shares Outstanding Chart
(Click to enlarge)

DTV Shares Outstanding data by YCharts

While companies like Exxon Mobil (NYSE:XOM) and Home Depot (NYSE:HD) also have done a good job of using buybacks to reduce shares outstanding, and others, like Merck (NYSE:MRK), have announced multi-billion dollar authorizations without following through in any way that has a real impact on shares outstanding, DirecTV is a standout. Not only has it reduced its shares outstanding dramatically, but that has helped contribute to a gain not only in earnings per share but also to a higher share price.

As YCharts reported recently, DirecTV is a stock Warren Buffett should brag about. The stock isn't all that pricey, with a PE ratio of about 14.

DTV Shares Outstanding Chart
(Click to enlarge)

DTV Shares Outstanding data by YCharts

True, there is an argument to be made that the reason DirecTV was able to undertake such an aggressive buyback was that, while its fundamental business was generating enough cash for the company to buy back stock, it wasn't offering a lot of potential sources of new growth in which that capital could be invested. Recent reports suggest that the satellite broadcasting company may have found a way around that: DirecTV is pondering making a bid for privately-held Hulu, which would give the company a toehold in the rapidly growing Internet streaming part of the broadcasting business.

Buffett, however, is confident enough in DirecTV's franchise and future that Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has been an enthusiastic buyer of its shares, adding to his holdings throughout 2012 and into the first quarter of 2013.

There is no such thing as a free lunch in the financial markets, any more than there is anywhere else; investors should be wary whenever they feel tempted to react to news of a big proposed buyback by snapping up the shares in anticipation of a market response. Companies may end up buying back stock not because it's cheap but because it has run up in price and employees are exercising options; they may announce buybacks because, like Apple, when their stock price is low but also because they are sitting on a pile of unused cash and they are under pressure from shareholders to do something. Before acting on buyback data, it's important to examine the motivations, evaluate the alternative uses to which the company could put that cash, ensure that the company intends to follow through on the authorization and actually repurchase shares, and establish whether that will produce a measurable decline in the number of shares outstanding.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.