Will Stock Buybacks Bite Back?

Mar 21, 2014

THE INTELLIGENT INVESTOR

Will Stock Buybacks Bite Back?

JASON ZWEIG

As the bull market soars ever higher, investors face big competition for buying the shares of companies—and it comes from the companies themselves.

Last year, the corporations in the Russell 3000, a broad U.S. stock index, repurchased $567.6 billion worth of their own shares—a 21% increase over 2012, calculates Rob Leiphart, an analyst at Birinyi Associates, a research firm in Westport, Conn. That brings total buybacks since the beginning of 2005 to $4.21 trillion—or nearly one-fifth of the total value of all U.S. stocks today.

There has been a lot of talk in the past few years about how index funds, which buy and hold stocks regardless of whether they are cheap or expensive, might be contributing to an overvaluation of the U.S. stock market. But the companies that make up the U.S. stock market might be contributing even more. And, if you wanted a signal of when to get in and out of the market, doing the opposite of whatever companies themselves are doing would serve you pretty well.

The Russell 3000 returned 33.5% last year, including dividends. At the end of 2012, the stocks in the index were trading at an average of 16.7 times their net earnings; by year-end 2013, the index was at a multiple of 20.6 times.

So, even as stock prices rose by a third and became a quarter more expensive relative to underlying profits, companies bought their own shares back more aggressively than the year before.

To be sure, corporations should favor a buyback when shares are trading below the total value of their future cash flows and when capital expenditures or acquisitions don’t appear likely to offer a higher rate of return. And investors ought to welcome a repurchase, since it should increase earnings per share—so long as the company isn’t overvalued and can finance the buyback cheaply.

Yet companies tend to exhibit the same perverse timing—buying high and selling low—as individual and institutional investors. As the market hit a then-record high in the third quarter of 2007, corporations bought back more than twice as much of their shares—$214.3 billion worth—as they did in the depths of the bear market. In the final quarter of 2008 and first quarter of 2009 combined, repurchases totaled only $97.3 billion.

“At the bottom, everybody sits on their hands,” says Michael Mauboussin, head of global financial strategies at Credit Suisse. “They don’t do anything when stocks appear to be cheap. But when stocks are expensive, then they buy back shares hand over fist.” The managers of companies might sometimes seek to offset the issuance of new shares when stock options are exercised; often, they are subject to the same fear and greed as anyone else.

Some companies, though, seem to have learned from the financial crisis. From the first quarter of 2005 through the end of 2006, between 8% and 12% of all buybacks were made by companies whose shares were the most expensive, says Mr. Leiphart of Birinyi. Last year, however, the companies whose shares were the most richly priced repurchased them at only half the pace of 2005 and 2006.

Moreover, it appears that buybacks aren’t about to revisit the peaks of 2007. So far this year, all U.S. companies have bought back a total of $15.4 billion, according to Birinyi—about the same level as this time last year, implying that 2014’s pace will roughly match that of 2013.

And last year’s total was well below the all-time high of $728.9 billion in 2007, when banks binged on buying back their own shares right before they collapsed in the financial crisis.

“Over the past couple of years, the thinking has been that once people got secure with the market, they’d open the coffers and spend willy-nilly to buy back shares and we’d return to the levels of 2007,” Mr. Leiphart says. “But companies haven’t opened the floodgates like that.”

It is possible, Mr. Mauboussin says, that “maybe they’re painted into a corner and that’s all they have to do.” If the prospects for the growth of a business look dim, managers might not want to shell out for capital expenditures or research and development that won’t pay off for years—preferring instead the instant gratification of buying back stock.

Taken to extremes, that wouldn’t be healthy. In 1924, the pioneering investment theorist Edgar Lawrence Smith pointed out in his book “Common Stocks as Long Term Investments” that the ability of companies to plow earnings back into developing the future growth of their businesses is “a practical demonstration of the principle of compound interest.”

If share repurchases consume too much of companies’ excess profits, the underlying businesses might end up starved, which could lower future returns.

So the surge in buybacks is worth watching closely. If companies end up chasing their own shares as high as they did in 2007, a fall to earth might not be far behind.