Falling Stock Prices And Share Buyback Programs
Summary The bear market is making share buybacks cheaper for companies. Smart companies will leverage this market and buyback more shares. Buying PKW or a few buyback achievers in this bear market will yield above-market returns for investors with a long-term time horizon. This bear market is causing short-term pain and panic for investors, but it is also making one particular feat of financial engineering even more appealing: share buybacks. The stock buyback idea is simple: companies generate cash flow from operations, and they use that cash to buy stocks on the open market at market prices. In short, companies buy their own stock through profits, which in turn lowers the total amount of shares outstanding. That will then raise the earnings per share ratio since the denominator is being reduced by the buybacks. Share buybacks have become more common since 2008, and they’ve become controversial. This summary of why buybacks are criticized is worth reading. The main concerns are threefold: By buying shares, a company may be overpaying for its own shares, especially if the shares are trading above book value. Companies should invest excess profits into research and development to grow revenues instead of buying back shares. Companies can actually raise the float of the company even as they buy shares, if they issue shares to employees or executives while also engaging in a buyback program. A company’s history of share issuances and buybacks should be analyzed carefully before buying. With these caveats in mind, there are reasons to like share buybacks and the companies that invest in them. Companies with excess profits, like Apple (NASDAQ: AAPL ), have enough cash lying around for buybacks, dividends, and investments. After AAPL began issuing dividends and doing buybacks, it purchased Beats, acquiring a popular and high-margin headphones manufacturer and music streaming service, and cash on hand still rose to over $200 billion . When a company cannot stop accumulating cash and has enough to consider a stock buyback, the pace and amount of a buyback program needs to be planned meticulously with a macroeconomic view in mind. This is where management effectively becomes a macro hedge fund, planning on when to buy its own company’s stock based on how the market will treat the company in the future. Likewise, investors need to consider this as well, for one simple reason: buybacks yield higher returns in bear markets. A hypothetical example of a share buyback problem by a company with a $10 billion market cap and a $5 million share buyback program makes this clear. In a bull market, the company ends up buying less shares than in a bear market – and a faster buyback program buys even more than a longer one. The chart above tells us something interesting: more aggressive share buyback programs and a bear market are good for shareholders. They reduce the total number of shares outstanding by a larger amount for the same amount of money spent; in fact, a more conservative share buyback program that lasts twice as long will result in more than half the amount of shares reduced in a bull market. Bear markets send a clear signal to management: aggressive share buybacks will benefit shareholders, and more aggressive ones can offset selling pressure that is coming from a broader panic. They can also benefit shareholders in the interim if the bear market continues. The Easy Way: PKW Thus, paradoxically, a bear market can benefit the buyback achievers. However, timing the purchase of those achievers and ensuring they will maintain enough free cash flow to continue, or even accelerate, buybacks is the tricky part. An easy way to make this bet is to buy the PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ), which attempts to hold companies that have reduced outstanding shares by 5% or more in the past 12 months. This simple focus means the company ends up holding a group of great companies across sectors, most of which have strong business fundamentals while also aggressively returning capital to shareholders by buying shares. Part of the beauty of PKW is its low exposure to energy, a beaten up and feared industry due to falling oil prices, and its relatively high exposure to consumer discretionary stocks. If this bear market is unrelated to the fundamentals of the economy, and Americans really are returning to work and will start spending more, this allocation will benefit investors on top of the buyback play. Looking at the fund’s holdings directly, we see some impressive names: PKW isn’t perfect: its holdings include companies that are facing serious headwinds, most notably International Business Machines (NYSE: IBM ), the fund’s second largest holding. IBM is seeing double-digit revenue declines and may struggle to maintain buybacks, let alone profitability, if it cannot stop those declines from worsening. Express Scripts (NASDAQ: ESRX ) has recovered from steep revenue declines in 2014, but its top-line growth has been tepid and below inflation, indicating a real decline in revenues. Stockpickers’ Alternative A better way to outperform in this bear market may be to target companies with a history of strong buybacks, rising revenues, and the potential for higher FCF. What companies fit the bill? Home Depot (NYSE: HD ), Apple, Boeing (NYSE: BA ), Monsanto (NYSE: MON ), and Time Warner (NYSE: TWX ) all have strong revenue growth and a solid track record of large share buybacks. Even excluding the buyback factor, a purchase of these companies yields a portfolio with a P/E about 20% below the P/E of the entire S&P 500. If an investor believes this bear market is likely to continue and has a long-term time horizon, buying large-cap dividend-yielding stocks, which traditionally provide strong positive returns over a long-term time horizon, is a smart decision. But an even smarter decision may be to focus those purchases on buyback achievers, thereby benefiting even more from the bearish hysteria of the current market. Disclosure: I am/we are long BA, HD. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.