The Rally Will End When Share Buybacks Slow Down

Includes: DIA, QQQ, SPY
by: Vahan Janjigian, CFA

I pay close attention to corporate earnings announcements and I have noticed what appears to be a common occurrence. A rather large number of companies are buying back their own shares and announcing an increase in share repurchase plans. Buybacks have long intrigued me because of the various ways they could be interpreted.

The most obvious reason for a buyback is because management can't find anything better to do with the money. That's sad. After all, companies are in business to make money. It's not a good thing if they can't find profitable investment opportunities. Of course, returning the money to shareholders through buybacks or dividends is better than wasting it on unprofitable investments or nonsensical acquisitions. Still, you would think that healthy growing companies would not have trouble finding good ways to put cash to work.

A second justification for a buyback is that management is convinced that the stock is undervalued. Clearly, there are times when a company's stock gets oversold for no good reason. And as every investor knows, it's always good to buy low and sell high. So buying back the stock when it is undervalued is a good idea. Unfortunately, many companies are not very good at timing their buybacks. As a result, they often end up buying high.

A third reason to buy back stock is to boost earnings per share. A share repurchase reduces the number of shares outstanding; and if we divide the same amount of net earnings by fewer shares, we get greater earnings per share. If the P/E ratio remains constant, the stock price will go up. But are investors really fooled by this kind of accounting gimmickry? Some corporate managements apparently think so. However, investors might conclude that the new capital structure merits a lower P/E, in which case the stock price will fail to rise despite the higher EPS. Still, even if the stock price falls, that's not necessarily bad for the executives if their total compensation is tied to EPS.

Interestingly, corporate earnings reports rarely brag about the increase in net income. They do, however, often brag about the percentage increase in EPS. You should feel some level of discomfort if EPS goes up at a higher rate than net income does. In fact, if the company has repurchased a large enough number of shares, EPS could actually rise even if net income falls.

While reading up on buybacks, I came across an interesting publication called FactSet BuyBack Quarterly, which documents a peak in buybacks during Q3 2007 (just as stocks hit a high) and a precipitous decline in buybacks through Q2 2009 (just as stocks hit a low). Of course, stocks have climbed higher ever since 2009; but so has the dollar value of share buybacks. Buybacks at S&P 500 companies climbed 12.3% year-over-year in Q2 2013 to $122.8 billion. Big share buyers during the quarter included Apple (NASDAQ:AAPL), Merck (NYSE:MRK), General Electric (NYSE:GE), and Exxon Mobil (NYSE:XOM).

I raised some concerns in my November 22 post that low interest rates have allowed corporations to finance share buybacks with cheap money. The FactSet report suggests that share buybacks and the level of the S&P 500 Index are correlated. Although buybacks have climbed in recent periods, the stock market has climbed even more. Now that expectations for higher interest rates are on the rise, I would not be surprised to see a decline in buyback activity. That would eliminate an important source of support for the stock market; and if the past is a reliable guide, it could also cause a significant selloff.

Disclosure: No positions.