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posted on 07 November 2015

Market Reflections: Do Share Buybacks Tell Us About The Markets Direction?

by Gene D. Balas

Appeared originally at United Capital Blog, 06 November 2015

Some investors may have caught the CNBC news article suggesting that, because a metric of share buybacks had recently trended down, the market might be at a top. Since the article didn't mention why this is so, much less why buybacks are even important, we thought we would join in the discussion and elaborate, offering our own thoughts.

We'll begin by noting that the analyst who offered these views, Ari Wald, did caveat some of the conclusions and offered a more tempered outlook, despite the headline hyperbole in the CNBC article that seemed to herald an impending market crash. So, now that you've had a chance to take a look at the article above, we'll digress from the article's "emergency broadcast system" message and turn instead to the market mechanics behind such a dire forecast. We'll see that there are multiple reasons why this trend line can go up (or down).

The analyst does have a point - share buybacks are important. And he may well be correct in his observation, so let's delve deeper into this topic. Standard and Poor's compiles an index of companies issuing buybacks. According to Standard and Poor's, the S&P 500 Buyback Index delivered a 10.08% annualized return for the ten years through September 30, 2015. That compares to the S&P 500 index return of 6.80% during that period. Over the past three years, that performance differential is even greater: the S&P 500 Buyback Index returned 17.39% in the past three years, while the S&P 500 Index growth averaged just 12.40%. However, the S&P 500 Buyback index lagged in recent months, losing -8.84% (not annualized) in the first nine months of this year, versus a loss of -5.29% for the S&P 500. The question is: does this underperformance represent a significant enough signal, on its own, that investors should be concerned?

To begin, some companies that are buying back shares may have profit levels that permit allocation to ample investment opportunities as well to share buybacks. In other words, they may return cash to shareholders because they may be highly profitable to begin with and are already growing robustly. This argues in favor of why an index of companies buying back their shares had outperformed the broader market. Since the price of shares depends on supply and demand, a company buying back its own shares adds to that demand - not to mention it sends a powerful signal to the market of the company's confidence in its own business.

Conversely, other companies may have ample cash flow, but some of these companies might have a different issue, that of fewer profitable uses for that cash by investing in their businesses. Companies have a certain cost of capital that must be achieved before undertaking a new project. With inflation low, and U.S. economic growth sluggish (or even virtually nonexistent in certain overseas markets), some companies may find it difficult to identify expansion plans that clear their cost of capital hurdle. So, they may buy back their own shares instead, seeking to boost their share price, even in the face of lackluster corporate fundamentals.

Now, when the stocks of companies buying back their shares underperform the market, it might possibly mean that investors may believe that their future profits will be lower, and thus they may believe that buybacks - which may be one factor driving stock returns - may eventually be reduced. So, changes in investor sentiment towards companies engaged in share buybacks can sometimes be seen as a leading indicator of where corporate profits may be headed. (See attached Market Reflections we published recently for more on corporate profits.)

Additionally, stocks of companies buying back shares could, at times, be under pressure because investors may prefer those companies not to use their cash to add to the level of marketable securities (instead of instruments with lower potential volatility) on their balance sheets. In other words, if investors believe that the markets could suffer in coming months, companies with balance sheets that hold cash, with its higher perceived degree of "safety," instead of holding their own stock may be viewed as less of a risk. In some sense, then, investors may assess the composition of corporate balance sheets, almost as if it were an asset allocation exercise unto itself.

To sum up, is this recent underperformance a sizable and significant divergence that should give cause for alarm? Quite possibly, the answer is "no" - this group of companies might not be representative of the market as a whole. When the metric was higher, some companies may have been returning cash to shareholders because, as we mentioned, they may have been generating significant amounts of cash beyond their investment needs. Returning to the more "normal" situation of applying cash to investment is not necessarily a dire forecast - unless it is due to the perhaps foreseen potential for an environment of lower profits, either now or in the future.

Or it could be just the opposite: they may have neither sufficient opportunities to profitably expand their business nor return cash to shareholders. For example, energy firms may find it of little use to use their cash to expand exploration and production in the current environment, and their cash reserves may no longer support cash buybacks. Other companies may have company-specific issues that hinder profitability, broader economic forces notwithstanding. Thus, with an index of just 100 companies, just a few sectors or companies can cause a material divergence in the performance of the S&P 500 Buyback index versus that of the S&P 500 index.

So, the long and short of it is that paying attention to corporate profits - and economic data - are certainly necessary for portfolio managers to consider. However, whenever following a simple metric, such as that of companies buying back their own shares, substantially more in-depth interpretation of these data is essential before determining whether an investor should buy or sell. And while a market correction is possible at any time, a single indicator such as this might not be empirically proven to be completely reliable by itself. There are often no shortcuts to investing.

By Gene Balas, CFA

Definitions

S&P 500 Buyback Index - The index provides exposure to the 100 constituent companies in the S&P 500® with the highest buyback ratio in the last 12 months. At each rebalancing reference date, the buyback ratio is defined as the monetary amount of cash paid for common shares buyback in the last four calendar quarters with interim reports available divided by the total market capitalization of common shares at the beginning of the buyback period.

S&P 500 Index - The Index measures the performance of the large capitalization sector of the US equity market. It is a capitalization-weighted index from a broad range of industries, and is typically viewed as a proxy for the broad US equity market.

Disclosures

Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.

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