In Barron\u2019s<\/b> Up & Down Wall Street column, titled \u201cBuyback Bonbons,\u201d Kopin Tan marvels that \u201cCompanies have already repurchased a staggering $445 billion worth of shares in the 12 months ended on September 30.\u201d\u00a0 According to Josh Brown of the Reformed Broker blog, this is enough to buy more than half the real estate in Manhattan.\u00a0 Tan writes the buy-back bonanza \u201cmerely reflects the abundant cash sloshing through our markets, and the dearth of convincing, good ideas for just exactly what else to do with it.\u201d Josh Brown opines that in a low-growth environment buy-backs \u201care less risky career-wise for a CEO or a board of directors than expansion or acquisitions.\u201d\u00a0 Recently Pimco\u2019s Bill Gross noted \u201cStocks have their own QE: \u2018corp buybacks\u2019 at $500 billion a year.\u00a0 They are a main reason stocks go up.\u00a0 When do THEY taper?\u201d\u00a0 The overall impression we get is that buy-backs are an artificial and unsustainable boost to stock prices resulting from misallocation of corporate capital.<\/p>\n
Buy-backs\u2019 Two Functions<\/b><\/p>\n
This buy-back hype is misleading because it does not take into account a second reason, in addition to returning capital to shareholders, why companies repurchase shares: to prevent \u201cshare count creep\u201d from employee stock options.\u00a0 If companies did not buy back shares and the share count increased, earnings per share would decline.\u00a0 My former colleague David Bianco, Chief U.S. Equity Strategist at Deutsche Bank, wrote a great report on this topic back in November.\u00a0 According to him, S&P 500 companies spent 5% of market cap on net buy-backs over the past two years but shares declined only 2.3%.<\/b>\u00a0 In effect, about half<\/b> of the \u201c$500 billion\u201d ballyhooed by Barron\u2019s<\/b>, Brown & Gross is not a return of capital to shareholders, but employee compensation.<\/b><\/p>\n
The mechanics, as explained by David Bianco, are as follows.\u00a0 In the cash flow statement the \u201cfunds spent on buy-backs\u201d figure is a net<\/b> number:\u00a0 expenditures on buy-backs minus<\/b> money received by companies when they issued shares to employees who exercised stock options. Shares are repurchased at the market price, which is higher than the strike price<\/b> at which stocks are sold to employees exercising their options.\u00a0 Therefore the percentage decline in shares outstanding<\/b> is significantly less than (net buybacks as a percentage of market cap)<\/b>.\u00a0 Here\u2019s a simple example.\u00a0 Assume XYZ Corp. has 100 shares outstanding, with a market price of $10, implying a market cap of $1000.\u00a0 If XYZ buys back 20 shares at the market price of $10 each ($200 total) and sells 10 shares to employees for $5 each ($50 total), then:<\/p>\n A Modest Boost to EPS Growth<\/b><\/p>\n The reduction in the S&P 500 aggregate share count from buy-backs boosts S&P 500 EPS by shrinking the index divisor, which is declining 1-2% annually.\u00a0 This is not trivial, but with index EPS rising 6-9% in 2013 and 2014 share buy-backs definitely are not the main driver of earnings growth<\/b>.\u00a0 The reality is that firms\u2019 allocation of cash is currently quite rational and shareholder friendly.\u00a0 Firms are not afraid to invest for growth where opportunities exist, but capex is disciplined\u2014unlike the behavior of tech and telecom firms in the late 1990s or of big banks during the housing bubble.\u00a0 Judicious investment preserves profit margins by preventing over-capacity.\u00a0 Meanwhile, firms are raising dividends rapidly and buying enough shares to boost overall EPS modestly\u2014which is a lot better than the share count creep<\/b> which usually occurred in the past.\u00a0 M&A activity has also been disciplined.<\/p>\n Why Timing Is \u201cTerrible\u201d<\/b><\/p>\n One other point. It is often said that companies have \u201cterrible timing\u201d when they buy back stock, because they buy more at the top of the market than during recessions.\u00a0 My first response is: Join the club! \u2013 most people are terrible market timers, so why should companies be any different?\u00a0 Aside from that, companies need<\/b> to repurchase more shares when the stock market is strong, the price of their own stock price is rising, and more employee stock options are \u201cin the money.\u201d Also, it is better to buy back stock near the top of the market than to make dumb acquisitions.\u00a0 By the way, during the next recession all the strategists who now criticize corporations\u2019 market timing will be churning out lists of \u201csafe\u201d companies with strong balance sheets, giant cash hoards, and minimal debt\u2014not the ones that are buying back lots of stock.<\/p>\n True Yield<\/b><\/p>\n In measuring how much capital a company is returning to shareholders, one should not<\/b> look at money spent on buy-backs, but rather at the actual shrinkage in share count<\/b>.\u00a0 \u201cTrue Yield\u201d \u2013 a measure of the total amount of capital returned to share holders \u2013 equals (dividend yield + annual percentage decline in shares outstanding).<\/p>\n A profitable, well-managed, mature growth stock should be able to grow EPS 6-12% (through a combination of organic growth, acquisitions, and share buy-backs that reduce the share count 1-3% annually) and also offer a dividend yield of 2-3%. \u00a0That implies a total return of around 8-12%, which is not bad when 10-year Treasuries yield 3%. \u00a0A few companies shrink their share counts far more aggressively; Eddie Lampert\u2019s Autozone comes to mind.<\/p>\n Copyright Thomas Doerflinger 2014.\u00a0 All Rights Reserved.<\/p>\n","protected":false},"excerpt":{"rendered":" In Barron\u2019s Up & Down Wall Street column, titled \u201cBuyback Bonbons,\u201d Kopin Tan marvels that \u201cCompanies have already repurchased a staggering $445 billion worth of shares in the 12 months ended on September 30.\u201d\u00a0 According to Josh Brown of the … Continue reading \n