Dividends tend to be the most celebrated way that companies return cash to shareholders, and it’s because it’s the most direct. A company literally pays you cash for the shares you hold, and you decide how to invest that cash from there.
However, stock buybacks — while their effect isn’t as direct — have long been another extremely common way to reward shareholders.
At least until recently.
The power of stock buybacks. The idea behind stock buybacks involves a little math, but is still pretty straightforward.
“Buybacks add upward pressure,” says Howard Silverblatt, senior industry analyst for index investment strategy for S&P Dow Jones Indices. “If you do enough of that, to overcome options, M&A and anything you issue, you reduce your share count and your EPS goes up.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
For instance: Silverblatt used the example of a company that earns $1 million. Divide that by a million shares, and that’s $1 per share. If you buy back 4 percent of your shares and earn a $1 million next quarter, you’re diving $1 million by 960,000 shares, so your earnings per share automatically rise to $1.04. “You made the same money,” he says, “but you’re dividing it by fewer shares.”
It’s that math that has helped spawn a few buyback-focused exchange-traded funds, such as the TrimTabs Float Shrink exchange-traded fund (ticker: TTAC).
“Charles Biderman (founder of TrimTabs Investment Research, which spawned independent TTAC provider TrimTabs Asset Management) was one of the first to look at corporate events from an investment point of view, such as offerings, buybacks, dividend increases and the like,” says TTAC portfolio manager Ted Theodore. “The more research that was conducted, the more it became obvious that a pretty clear edge goes to investors who enjoy a bigger piece of the pie, and the way that happens is the share count goes down, the float shrinks. It’s been a very potent factor for a number of years.”
Not that buybacks are an absolute good. Will Ashworth, freelance analyst, doesn’t look at buybacks’ effects as math — but an “illusion.”
“In recent years as companies have seen their earnings increase, share repurchases have become a big piece of CEOs capital allocation pie. That in turn has created the illusion of even faster EPS growth, which has pushed up stock prices to record highs,” he says. “The worst part of this reliance on buybacks is that it’s come at the expense of balance sheets with many companies borrowing at record-low interest rates to reward shareholders beyond dividends and capital appreciation. As interest rates rise, that debt will have to be repaid, which means future free cash flow that might have gone to making the business better will go to lenders instead.
“Ultimately, shareholders lose,” Ashworth says.
Depending on which side of the fence you sit, then, recent information about the direction of stock repurchases is cause for concern, or celebration.
Are buybacks falling out of favor? The most recent FactSet Buyback Quarterly report shows that Standard & Poor’s 500 index companies’ spending on stock buybacks crawled to just $115.6 billion. That’s down 28 percent year-over-year — the worst drop since the third quarter of 2009 — and the smallest amount spent in any quarter since the third quarter of 2013.
That, despite the fact the third quarter typically is the strongest for share repurchases. But not only was the dollar amount off — so were the number of S&P 500 components engaging repurchases, from 392 in the third quarter of 2015 to 362 in the same quarter this year. Worse, it comes just a couple quarters removed from the record $589.4 billion repurchased in the 12-month period ended March 2016.
But why?
A little of the blame could go to the investing environment. While the S&P 500 actually rose more than 3 percent during the quarter, much of that came amid Brexit anxieties and a leveling off in August and September as the markets started to look ahead to the U.S. presidential election.
Moreover, while several sectors contributed large year-over-year drops in repurchases, energy and materials registered materially outsize declines — 62 and 55 percent, respectively — a reflection of cash struggles amid continued low commodity prices.
But the real culprit might just be a trick of timing.
In the first quarter of this year, investors spent $161.4 billion on buybacks, ranking as the second-largest spend on repurchases in history. That set the tone for the rest of the year — just not in the way you’d expect.
“What happened in the first quarter of 2016 is the market went down 10.5 percent through Feb. 11,” Silverblatt says. “Companies said, ‘We are going to buy stock, this is just market conditions, everything is fine.’ Companies bought more to help support their stock. Come Q2, the numbers declined. It appeared they overbought in Q1, but they just didn’t change their allocations for the year.
[See: The 25 Best Blue-Chip Stocks to Buy for 2017.]
“So say they were going to do $1 billion the whole year. Instead of doing $250 million each quarter, say I did $350 million in the first quarter — I’m not increasing the year to $1.1 billion, I’m cutting back for Q2. That was the working theory on why Q2 declined,” he says. And prior to FactSet’s report, Silverblatt said that’s what the running third-quarter numbers supported.
So this likely isn’t a cash problem — in fact, Silverblatt says, “I’ll give you odds — cash will be at an all-time high this year. Companies had the ability to do what they want; they chose not to.”
FactSet’s third-quarter findings would seem to back this up: “At the end of Q3, 109 companies in the Standard & Poor’s 500 index spent more on buybacks in the trailing 12 months than they generated in free cash flow. This represented the lowest count since Q2 2013.”
A new “Trump bump.” The market has run more than 6 percent since Donald Trump won the presidential election, fueling sectors like financials amid the belief that profit-pinching regulations will be torn down, and groups like infrastructure stocks that could receive a lift should Trump succeed in pushing forward a massive infrastructure spend — one of his highest policy priorities.
But another factor that pushed the likes of Apple ( AAPL) and others higher is the potential for a big one-time cash influx.
“Trump’s planned tax overhaul includes a tax holiday that will encourage companies who have been accumulating cash overseas to bring that money back into the United States,” says FactSet’s report. “If this occurs, some of the largest companies will be sitting on piles of excess cash, which may very well be used to repurchase more stock.”
To Silverblatt, it’s an inevitability.
[See: 8 Ways President Donald Trump Will Affect Wall Street.]
“Every dollar the U.S. government gets, they don’t have to cut another program. Congress wants that money,” he says. “The hope is that companies will do some sort of hiring to help the U.S., or buy equipment. But it will definitely leak through. So there will definitely be buybacks — the question is ‘How much?'”
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Are Stock Buybacks Really Dead? originally appeared on usnews.com
