There was an interesting article in The Wall Street Journal on Friday about how companies are slowing down stock buyback programs. This is one way in which companies return money to shareholders – they use some of the extra cash they are generating to buyback shares, taking them out of the market and reducing the number of shares out there. Theoretically, this makes the remaining shares more valuable, thereby rewarding shareholders. I’d say that the jury is still out on whether this actually works.
One thing share buybacks definitely do is to increase the earnings per share since there are fewer shares out there even if earnings remain the same. Because many investors use earnings per share to judge how well a business is doing, reducing the share count might lead to additional investments and higher share prices. I always look for a string of earnings per share increases when evaluating a stock. That said, seeing EPS increase just because the share count is being reduced is questionable. Kind of like saying that your car is faster because you’ve installed smaller tires that make your speedometer read fast.
The main reasons that a company buys back shares are to 1)reduce the dilution caused when they issue shares and options to employees and executives and 2) because they don’t have good places to invest the money, so they figure they should just reduce the number of shares out there. It appears that the latter has been true for the last several years with share buybacks reaching very high levels from 2011 to 2016 as a sluggish economy has caused many corporate boards to hunker down and wait for conditions to improve. This meant that share prices increased, but the overall economy was relatively stagnant. From the Journal: “The postcrisis surge in buybacks has been frequently cited by stock-market bears as a sign that the market’s eight-year advance has been driven more by financial engineering than by long-term growth.”
Since the election of Donald Trump and the proposed tax cuts, along with cuts in regulation, companies are thinking that the economy may pick up and they may be able to expand again. In particular, rollbacks in regulations associated with The Affordable Care Act, such as the requirement that businesses with more than 50 full-time employees provide health insurance, may lead to growth since companies could hire more workers and have more workers full-time (or even overtime) without incurring a big change in labor costs for passing from 49 to 50 workers.
Why this should be interesting to investors is that the current stock market rally, which has gone on for about eight years now, may be able to continue despite the relatively lofty evaluations. Price to earnings ratios will eventually return to historic averages, but that can occur by stock prices declining or by earnings increasing. If companies expand and see earnings increase, current stock prices may become more justifiable, allowing share prices to hold their gains and maybe continue on for a while. The end may not be as near as prognosticators are predicting.
That said, stock prices may already reflect a lot of the expected growth, meaning that as earnings increase due to sales increasing, instead of due to stock buybacks, share prices may remain stagnant since the good news is already priced in there. We may even see the scenario where earnings increase, but not by as much as investors were expecting, so share prices may actually decline. The lesson, as Yogi Beara used to say, is that predictions are always hard, especially when they are about the future.
So what is the investor to do? The answer is the same as it always is: Invest money that is not needed for the next five to ten years and invest regularly. It is hard to say where the market will be in three years, but in ten years it will very likely be up. Over long periods of time, stocks will perform better than CDs, bonds, or any other interest-bearing asset. This is because the stock investor is taking more risk than the income investor and prices are set to reward investors accordingly. If there is a decline as share prices reset from the big run-up we’ve seen, it will just mean that there will be bigger profits to gain when share prices rebound to current levels and beyond.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.