This Rally Has Been Buoyed by Buybacks

Many people are scratching their heads at this continued rally, but they should note: stock buybacks have played a major role

   

At the end of the day, movement in the U.S. stock market boils down to the simple forces of supply and demand. Stock prices move higher when demand for stocks increases or the supply of stocks decreases. Conversely, stock prices move lower when demand for stock decreases or the supply of stocks increases. It’s as simple as that.

Well…okay, it’s not always so simple to determine when demand is increasing or decreasing, but it is a little easier to determine when supply is increasing or decreasing. In fact, right now is one of those times in the market when supply is decreasing, and stock prices are benefiting because of it.

Companies Decreasing Supply to Increase Demand

The reason there are fewer and fewer shares of stock to trade is that companies are buying back their shares in droves. When a company finds itself with extra cash on its books, it can reinvest the money back into the company, it can disperse that money to current shareholders in the form of a dividend or it can buy back shares of its own stock.

In the current economic environment, many companies are pulling back on their capital expenditures (CAPEX). They have already spent the past few years cutting costs and improving efficiencies, and unless consumer demand starts to pick back up, there isn’t a lot of expansion that needs to take place.

Some companies have bumped up their dividend payments, and a few have even started new dividend programs. However, many companies have shied away from paying dividends. Unless you make it clear you are issuing a one-time dividend, starting a dividend program is a long-term commitment because once you start paying a dividend, you have to continue paying a dividend forever. Companies that cut their dividend payments, or stop paying them altogether, are considered to be investment risks and typically see their share prices fall.

That leaves us with share buyback programs. During the past few quarters, we have seen a bevy of companies announce they will be buying back shares of their own stock. This does two things for a stock. First, it decreases the supply of the stock. If demand for the stock remains unchanged, this reduction in supply should drive the price of the stock higher. Second, it reduces the number of shares that can stake a claim to the company’s earnings. To calculate a company’s earnings per share (EPS), you divide the company’s total earnings by the number of shares outstanding. If you have fewer shares, each share receives a larger portion of the earnings, which should drive the stock price higher.

Impact of Share Buybacks

So what impact are we seeing in today’s market from these share buybacks? Answer: a bullish impact.

Of course, there are many other factors — most notably the actions of the Federal Reserve and other central banks around the world — that are contributing to the current bullish trend we are seeing on Wall Street, but share buybacks have certainly added fuel to the fire.

According to analysts at Pavilion Global Markets, who were cited in the recent Bloomberg article “Fewer U.S. Shares Available Fuels Bull Market,” share buybacks accounted for 25% of the EPS growth rate for S&P 500 companies during the past year. That is quite an impact.

Share buybacks are a widespread phenomenon. Although Apple (NASDAQ:AAPL) might be the most highly visible company to initiate a share buyback program — which will total $60 billion — this earnings season, many other companies are buying back shares at a rapid clip. According to a recent “Buyback Quarterly” publication from FactSet, companies from the energy sector to the health care sector, from the financials sector to the consumer staples sector are buying back stock. You can see in the figure below that Exxon Mobil (NYSE:XOM), American International Group (NYSE:AIG) and others have spent billions of dollars buying back their stock during the past 12 months (Source FactSet).

SST515 This Rally Has Been Buoyed by Buybacks

And the buying continues. Just yesterday, Ashland (NYSE:ASH), Arctic Cat (NASDAQ:ACAT), TriQuint Semiconductor (NASDAQ:TQNT) and Comstock Resources (NYSE:CRK) announced new share buyback programs.

Historically, share buyback programs haven’t always provided the best price performance for their respective stocks. As you can see in the figure below from FactSet, companies that have not engaged in share buybacks (blue line) have seen their stocks achieve much higher growth rates than the stocks from companies that have been involved in share buybacks (yellow and green lines).

SST2515 This Rally Has Been Buoyed by Buybacks

However, during the first part of 2013 (highlighted by the red box), companies that don’t pay a dividend but have engaged in stock buyback programs (yellow line) have been outperforming the stocks from other companies. This goes to show that at a time when many investors have been too nervous to buy more stock because they don’t know how long this current bullish trend can last, you can still count on the companies with buyback programs to keep on buying.

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