Understanding the Unprecedented Amount of Stock Buybacks

by: Andrew Corn

There has been a lot of press and subsequent comment in the blogosphere concerning the unprecedented amount of stock buybacks, meaning companies buying their own stock.

To give you an idea of the magnitude of stock buybacks, S & P issued a statement last quarter that companies in the S&P 500 index bought back $110 billion in stock during the third quarter of 2006, which is up 35% from a year ago. It was the twelfth consecutive quarter of greater-than 20% growth in buybacks for the index, and just below the record $117 billion in buybacks conducted in the second quarter.

The perceived impact on the market is what is causing all the clamor, but before we get to the 2006 version of this, I want to share what we were thinking five and ten years ago. Back in those days, many buybacks were considered poor management. Translated: if management could not develop strong enough projects to increase revenue and profit growth organically (projects that require funding), then the next best thing to do with the cash would be a strategic acquisition or perhaps a special dividend. The only real use of buybacks back then was to have enough shares on hand to dish out to managers, senior and otherwise. There were of course exceptions.

Today, the issues are somewhat different. The mainstream media appears to assume that investors, even sophisticated ones, may not understand the formula which is profit divided by the number of shares equals earnings per share [EPS]. If the number of shares is reduced via buybacks and earnings remain constant then EPS goes up, which is rather obvious to those of us who can handle third grade math. The press calls this a material impact on earnings affecting over 20% of the S&P 500. They basically think that investors are so dumb that this simple equation is not understood or investors are not paying enough attention to the issues. Appearances are that earnings are accelerating faster because of buybacks.

Who are these seemingly devious big companies buying their shares back Q406? The big sectors are information technology 25%, energy firms 15% and financial companies 12%. They disclose the buybacks, the stock options issued and analysts' buy and sell side, calculate the costs, benefits and synthetic changes to earnings per share.

As quantitative investment managers, we have made no adjustments to our algorithms for the buybacks. Why?

The arithmetic is simple. We screen and rank other measures beyond EPS such as: Net Income, Cash Flow and Debt. If a company scores higher with its EPS with no debt, higher net income and increased cash flow, this is a scenario where the buyback may have been excellent use of firm capital. If the buyback was financed with debt, or it hurt cash flow, we score that appropriately.

To those of us used to looking at ALL the numbers, objectively and in a highly disciplined process, we do not consider the buyback talk worthy to be labeled shenanigans. We view each buyback as one facet of the overall picture of a firm. We then compare all of our scores for that firm with that of its peers and all of the companies in its investment style to assign it a ranking that may or may not qualify it for inclusion in one of our portfolios.