We’ve sen a host of big-ticket deals in February. These include Warren Buffett and Berkshire Hathaway (NYSE:BRK.A, BRK.B) teaming up with 3G Capital to purchase Heinz (NYSE:HNZ) for $23 billion, as well as PC icon Dell (NASDAQ:DELL) announcing its intention to go private for more than $24 billion.
These moves could be a bullish sign for investors, as private equity starts looking for opportunities to unlock value with buyouts that send shares soaring. But don’t think that just because your investments aren’t players in one of these deals that you’re going to miss out.
Share buybacks are on the rise across the board. And according to one renowned growth investor, share buybacks are a form of “mini buyout” where corporations “invest in themselves.”
Louis Navellier, the growth investor behind Blue Chip Growth and Emerging Growth, is getting pretty excited about the current environment as big-time stocks put big-time money into share repurchase plans.
“If Wall Street does not price a company properly, then they have the right to buy their stock back and go private,” Navellier told me. “These buybacks are truly a big story right now.”
Click to Enlarge This chart shows the surge of stock buybacks lately, pushing back to mid-2008 levels and topping $400 billion quarterly. Some of the recent share repurchase deals of note include a $10 billion plan from General Electric (NYSE:GE) and a $7.5 billion plan from chemicals giant 3M (NYSE:MMM).
Furthermore, since the Great Recession there are hints that stocks engaging in big buybacks have outperformed stocks plowing cash into bigger dividends. Check out the total returns here in this second chart, especially since the bear-market lows of 2009.
Click to Enlarge Navellier says the easy-money environment of low interest rates may continue to fuel buybacks going forward, too.
“Big companies can borrow at 3% or less in the bond market. If their ROE is 12% or higher, it is a no-brainer to borrow in the bond market and buy their stock back,” he said. “Corporate America is raising approximately $2 trillion in the bond market per year at the current pace. The last I checked, the stock market was only worth $18 trillion. So if Wall Street does not price their stock right, the entire stock market could just go ‘poof’ and largely disappear on stock buybacks.”
The Cost and Benefits of Buybacks
Proponents of stock buybacks claim the following benefits:
Click to EnlargeEPS boost: Earnings per share naturally inflate after a significant buyback, because you are lowering the “S” from all EPS calculations. For instance, if a stock earns $100 million and has 100 million shares outstanding, it has earnings per share of $1. If it buys back 10 million shares but earnings are flat, next year it would have $100 million in profits over 90 million shares outstanding — pushing up EPS to $1.11 by virtue of math alone. Consider this chart from The Wall Street Journal for real examples of how this has worked recently.
A sign of excess cash: Though Navellier points out companies can offer debt for buybacks, typically companies use cash. And if executives feel that they can spare a few billion on a buyback plan, it is often a clear sign that the underlying stock doesn’t have anything to worry about when it comes to cash flow.
A sign of confidence: As Navellier puts it, when a company buys back shares it is saying to the world that it sees “no better investment than itself.”
Those are all noteworthy factors in favor of buybacks and the companies that undertake them. But for balance it’s worth pointing out the following potential pitfalls that accompany buyback plans. Like everything in investing, buybacks are never a sure thing.
Consider this article I wrote a year or so ago, highlighting stocks that had spent huge amounts of money on buybacks … with mixed results. While some stocks spend billions on buybacks to big success, others like Microsoft (NASDAQ:MSFT) have spent over $100 billion in buybacks to see shares essentially move sideways.
Here are some of the reasons buybacks may be ill-advised:
Buying a top: Historically, corporate America has a poor sense of timing when it does buybacks. Consider the first chart above where buybacks peaked at $600 billion a quarter in 2007 and 2008. Not exactly the best period to be investing whole-hog in stocks. Or take the more recent example of Apple (NASDAQ:AAPL) and its $10 billion buyback plan. Apple’s repurchasing stated in October 2012 … when shares were in the high-$600 range. Shares are off about 25% since then.
Increased volatility: For some stocks that don’t trade a lot of shares, buying back stock increases volatility because of simple supply and demand. Fewer shares on the market means that buyers and sellers have less to work with, and thus a big headline or other such trading event that causes a spike in interest could result in big swings for prices due to constrained supply of stock.
The best-laid plans…: Always remember there is a difference between announcing a buyback and actually purchasing the stock. A good portion of announced buybacks are not executed in full. A company may approve a $10 billion plan but only buy back a fraction of that amount.
Earnings shenanigans: Many investors are hip to the fact that buybacks juice earnings and aren’t as willing to bid up a stock any more based on this kind of “growth.” While fundamental analysis may reveal an uptrend at first glance, stock buybacks can’t prop up momentum forever if the top line isn’t growing. Simply lifting earnings per share via a share repurchase sometimes isn’t enough.
- John Waggoner on why buybacks matter. (USA Today)
- The case for even more buybacks. (Y Charts via Yahoo Finance)
- What’s behind the buyout binge? (Advisor Perspectives)
- On the other side of the coin: Why stock buybacks are more harmful than you think. (Money Morning)
- Buybacks were up $274 billion in 2012 over 2011 numbers. (WSJ)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing he held a long position in Apple but no other stocks named here.