Slowing buybacks could spell trouble for U.S. stocks

Slowing buybacks could spell trouble for U.S. stocks

12:20pm EST

By Chuck Mikolajczak

NEW YORK (Reuters) – With just over a month remaining in a year that has seen the S&P 500 rocket to new records, one of the rally’s drivers could have peaked: stock buybacks. In the last few years, major U.S. companies, including IBM, Apple and Exxon Mobil have dramatically boosted share repurchases. Overall, Federal Reserve data shows corporations are the primary buyer of equities – while pension funds, mutual funds and households have increasingly been sellers in recent years.The reduction in share count helps improve earnings-per-share figures, one of the more important metrics investors use for valuing stocks.

But Fed figures show buybacks appear to have peaked last year. If companies start to ease off the pace of repurchasing their stock, it’s a red flag for a market that has depended on support from the corporate sector.

As the sluggish economy left companies struggling to manufacture growth – and profits as a result – many firms were reluctant to invest in hiring or capital investment, and instead turned to buybacks as a use for cash.

“It makes the earnings growth look stronger than the organic or secular earnings growth related to the growth in the economy or that individual company’s business,” said Mike O’Rourke, chief market strategist at JonesTrading in Greenwich, Connecticut.

“While earnings per share are growing, it’s not coming from organic growth in the economy, it’s coming from financial engineering, and that is a big concern.”

Federal Reserve data shows buybacks peaked at $508.1 billion repurchased in the second quarter of 2012, compared with $344.8 billion purchased in the second quarter of 2013.

That data includes companies not in the S&P 500. Restricting the data to the benchmark index, buybacks rose 18 percent in the second quarter – but Apple’s giant buyback announcement accounted for most of that, according to S&P. Without that, repurchases rose by just 2 percent.

The possibility of a scale-back in Fed stimulus that raises borrowing costs, along with a withering in corporate buybacks, will leave companies to rely on an acceleration in the economy to boost earnings over the next several months, a scenario many analysts view as unlikely.

BORROWING COSTS SET TO RISE

The conditions that make buybacks favorable – low borrowing costs and reasonably valued equity prices – may be diminishing, however. The S&P 500 and Russell 3000 indexes are each up more than 30 percent since June 30, 2012.

Some fund managers have concerns that companies are seeing return on equity decline, as their primary way of adding to shareholder value is through so-called financial engineering.

Exxon Mobil Corp, for instance, bought back $4 billion in shares in the second quarter, according to Howard Silverblatt, Senior Index Analyst at Standard & Poor’s in New York.

Over the last several years, the company’s free cash flow has diminished as it has boosted dividends and buybacks. In the first three quarters of 2012, Exxon paid $8.13 billion in dividends and bought back $12.7 billion in stock, leaving free cash flow of $9.46 billion. That’s its lowest level after nine months in a decade, excluding the recession year of 2009.

Exxon’s ability to continue along that path may be diminishing, as the company has taken advantage of low interest rates spurred by Fed stimulus to borrow.

“They used to be able to fund both (dividends and buybacks)” with cash flow, said Jim Chanos, president and founder of hedge fund Kynikos Associates. “At these low rates, it’s accretive, but that’s not (coming from) their business. It’s dependent largely on the Fed.”

But not all buybacks are likely to dry up, and those companies that continue stock repurchases may be rewarded.

Tobias Levkovich, chief U.S. equity strategist at Citi, notes there is a difference when looking at a group of companies that over several years have become what he calls “share shrinkers.”

A basket of those companies – including IBM, Hewlett-Packard, and Rockwell Collins – has outperformed the S&P dramatically, rising nearly 550 percent since 2003, compared with about 200 percent for the overall market, Citi data show.

“It becomes part of the corporate DNA to reduce the shares outstanding,” said Levkovich. “These are companies that continuously do it and those are the ones that tend to be really outstanding performers.”

For the overall market, however, when buybacks start to come off of a peak, it can be a sign that the market is hitting a peak. Fed data shows buybacks surged to $1.09 trillion in the fourth quarter of 2007, as the S&P crested. They stayed relatively buoyant for a few more quarters before slumping as the market dropped sharply.

If the economic environment makes earnings growth difficult, equities may finally appear expensive and give investors reason to back away from stocks that have been hitting a steady streak of record highs.

“If they are looking at the forward price-to-earnings ratio and saying stocks are cheap because they are factoring in a certain percent of buybacks and they suddenly dry up, that is not good,” said Scott Armiger, portfolio manager at Christiana Trust in Greenville, Delaware.

“That is one more thing to worry about, you put that on the list with the taper and the slow growth.”