The Stock Buyback Conundrum: Will Companies Keep It Up Much Longer?

Apr. 26, 2016 7:16 PM ETQUAL, SPHQ, USMV, TFI13 Comments
Gary Gordon profile picture
Gary Gordon
30.9K Followers

Summary

  • The notion that corporate share buybacks have been influential in propping up stocks is nothing new.
  • High ROE, low debt-to-equity and earnings strength may be preferable in one’s stock allocation to owning the “buyback-enhanced” benchmarks
  • With real yields ticking up from 0.0% to 0.4%, companies may not wish to pass up the perceived opportunity to fund share acquisitions through ultra-cheap debt issuance.
  • Total debt levels rising, net income declining, free cash flow falling, CEO realization of stock underperformance, and higher borrowing costs/credit access issues. Any combination of these items is likely to inhibit the buyback support to overvalued S&P 500 equity prices.

Some facts are more interesting than others. For example, Liz Ann Sonders, chief investment strategist and perma-bull at Charles Schwab, recently acknowledged that "... there has not been a dollar added to the U.S. stock market since the end of the financial crisis by retail investors and pension funds."

Let the reality sink in for a moment. "Mom-n-pop" investors as well as pension funds have not added to their U.S. equity positions during the seven-year plus bull market. That includes the last three months, in which major bank clients (e.g., hedge funds, private clients, institutional investors, etc.) have been net sellers.

Since every buyer has a seller (and vice versa), what group or groups had enough of a buying presence to push the S&P 500 14.2% off of the February closing lows? Corporations.

The notion that corporate share buybacks have been influential in propping up stocks is nothing new. On the flip side, the extent of the influence may be much greater than previously realized. Standard & Poor's 500 Index constituents acquired roughly $182 billion of stock in the first quarter of 2016 alone. Even today, with real yields ticking up from 0.0% to 0.4%, companies may not wish to pass up the perceived opportunity to fund share acquisitions through ultra-cheap debt issuance.

Unfortunately, debt-funded buybacks present a number of challenges. First of all, total debt levels for U.S. companies have doubled since the Great Recession. While many analysts focus solely on the current ability for companies to service their debt obligations, the capacity for companies to do so changes when borrowing costs increase, free cash flow sinks and/or net income declines.

Consider free cash flow after dividends. This refers to the cash flow from operating activities excluding fixed capital expenditures and dividends paid. In Q4 2015, companies spent 101.7% of free cash flow

This article was written by

Gary Gordon profile picture
30.9K Followers
Gary A. Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. He has 30 years of experience as a personal coach in “money matters,” including risk assessment, small business development and portfolio management. He favors tactical asset allocation strategies over "set-it-and-forget-it" investing.Gary is often asked to consult as an educator. He has taught financial concepts in Mexico, Singapore, Hong Kong, Taiwan and the United States.As a Certified Financial Planner (CFP), Gary has distinguished himself as a reputable and trusted investor advocate. Gary’s participation on local and national radio has spanned more than two decades. He writes commentary at his web log, TheStockBubble.com.

Disclosure: I am/we are long QUAL, TFI. 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.

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