The S&P 500 Buyback Index – which contains 100 stocks of companies in the S&P 500 with the highest ratio of buybacks – has fallen more than 8% over the past year, whereas the S&P 500 index itself is only down about 1% in the same time frame. Are corporate stock buybacks losing their bite? Or is there more than meets the eye with this short-term negative trend?
Let’s dig deeper into the reason investors have historically been attracted to corporate stock buybacks and then we’ll take a look under the hood of recent performance of the Buyback Index to glean any clues about market direction.
Why Corporations Buy Back Stock
To find out why some investors pay attention to corporate stock buybacks, you first need to understand why a corporation would want to buy shares of its own stock.
When a corporation buys back shares of its own stock, the effect is giving money back to the investors in exchange for more equity (ownership) of the corporation. At first this sounds counterproductive because the primary reason for issuing shares of stock to investors in the first place is to raise capital, which is then used to operate and grow the corporation. So why reverse that purpose?
There are a handful of reasons why corporations might buy back stock:
- Reduce the cost of capital: Paying dividends to investors costs money. And if there are no good uses of the capital, or no real growth opportunities available in the foreseeable future, it makes no sense to keep paying dividends to pay for that capital. Therefore it can make sense to buy back shares and cut the costs of paying dividends.
- Take advantage of undervaluation: If the company’s stock is oversold by investors, often due to short-term panic selling from an overblown media report, it can buy back shares at depressed prices then sell them back at higher prices after the short-term challenge has dissipated.
- Increase earnings per share, or EPS: A company’s stock can look more attractive to investors with a higher EPS. The simplified calculation for EPS is net income divided by average outstanding shares. Therefore, when a company buys back its own shares, it reduces the number of outstanding shares, which can then raise the EPS, even if net income stays the same.
In summary, investors that pay attention to corporate stock buybacks see their own buying opportunity. If a company is buying back its own shares, it may signal that the stock is a value play.
Why Corporate Stock Buybacks Have Lagged
So now we return to original point and question: Why haven’t stocks of corporations that buy back their shares done so well in the past year?
We can answer this question partially by taking a look under the hood of the SPDR S&P 500 Buyback ETF (NYSEARCA:SPYB). The top four sectors, consumer discretionary stocks, industrials, information technology and financials, which make up about 80% of the portfolio, aren’t combining for performance that beats the S&P 500 over the past year. Consumer discretionary and technology have outperformed the market but industrials and financials have lagged.
Another explanation is that corporations may be buying back shares to reduce the cost of capital, as explained in the first bullet point above. If they see no growth opportunities, why pay more dividends than necessary? Pull back the capital with buybacks and reduce costs!
A Comeback for Buybacks?
With all that said, stocks of corporations that buy back stock may be making a comeback. The S&P Buyback Index is up about 6% in March and is up more than 1% year-to-date 2016, while the S&P 500 Index is hovering around zero for the year. Although a few months of benchmark-beating performance doesn’t necessarily mean a longer positive trend is beginning for buyback stocks, it at least is a signal that the downside has subsided, for now.
Perhaps the smartest question and observation about corporate buybacks and the idea of investing in their respective stocks or ETFs, is that short-term trends and niche strategies carry their own risks. The trend is your friend until it ends. Buyer beware.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
This article is brought to you courtesy of Kent Thune from Wyatt Research.