Upside potential in US stock buyback programs
A new white paper by Nasdaq Global Information Services reveals that US companies that engage in stock buybacks generally outperform the market on an annualised basis and also experience lower volatility; the Holy Grail of investing.
“This is helped by the fact that buybacks act as a bit of a floor during periods of heightened volatility, and act as additional price support for companies even when their share price might be falling,” says Cameron Lilja (pictured), Director of Product Development, Nasdaq Global Information Services and author of the Stock Buybacks white paper, which published last month.
Stock buybacks are nothing new but the main takeaway from Nasdaq’s white paper is that when people talk about companies doing stock buybacks, they typically focus on how much money the company is spending on buybacks. Last year, for example, S&P 500 companies spent USD569 billion buying their own stock, representing the second largest year for buybacks since the Great Recession.
But as Lilja explains, the white paper does not focus on dollars spent, but rather the actual reduction in the number of shares outstanding that the company achieves as a result of the buyback program.
“When you look at how a company is buying back their shares, what we recommend to investors is to look at the bottom line. If they are buying back USD10 million of shares are they issuing USD5 million in new shares? Because if they are, you are only getting a net reduction of USD5 million.
“It’s a basic supply and demand story. If a company is still earning the same amount of dollars, but reducing the number of shares, then the share price will rise because there are fewer shares available. If instead of total shares outstanding we only considered total dollars spent on a buyback that’s really meaningless in terms of understanding the impact on share price,” explains Lilja.
Using data over a 13-year period provided by Ford Equity Research, whose equity universe database contains more than 4,000 US securities, Lilja and his team found that whilst the average annualised performance of stocks was +8.1 per cent, the performance of companies that had a net increase in total shares outstanding (‘TSO’) was +7.8 per cent compared to +10.4 per cent for companies that had a net decrease in TSO.
To extend the point further, companies that experienced a 5 per cent net decrease in TSO over the trailing 12-month period returned 11.6 per cent. It is these companies that qualify and go in to the Nasdaq US Buyback Achievers Index and as Lilja points out, “this index has performed better than the Nasdaq US Benchmark Index, particularly since late 2011, in addition to the S&P 500 Index.”
As buybacks tend to support a company’s stock price, this outperformance by the components of the Nasdaq US Buyback Achievers Index is not surprising. The PowerShares Buyback Achievers ETF (PKW) is the leading product that tracks the performance of the Index and currently has USD1.6bn in assets under management.
In contrast to the Nasdaq US Buyback Achievers Index, the S&P 500 Buyback Index relies upon a methodology that does not take into account the overall reduction in total shares outstanding. Rather, it is based on a “buyback ratio” of dollars spent divided by market capitalisation. The 100 securities with the highest buyback ratio are then equal-weighted to form the buyback index.
As Lilja points out in the white paper, there are two key differences to these indexes. Firstly, the Nasdaq Index uses the 2,700 stocks in the Nasdaq US Benchmark as its starting universe. The S&P Index only looks at 500 stocks and thus skews it heavily towards large-cap companies.
Secondly, the Nasdaq US Buyback Achievers Index requires a net reduction in total shares outstanding (TSO) of 5 per cent, even accounting for new share issuance, and allows for inclusion of all securities issued by a US company that meet this threshold.
Lilja believes there are two main reasons why US companies are engaging in stock buybacks.
Firstly, there has been a steady bull market and economic recovery in the US, but the general sentiment among CEOs is that the recovery has developed on fragile ground. Ordinarily, one would expect over the course of a bull market that companies might start investing in riskier growth-related activities, in research and development, in acquisitions and so on.
This simply hasn’t happened.
“In that case, they tend to return value to shareholders through stock buybacks rather than invest in these growth-related activities. Secondly, one has to consider the favourable interest rate environment. Companies are more willing to take on debt and finance buybacks because of how low rates have been, and continue to be.
“We’ve had a good recovery in the US stock market since ’08 but the economics of that recovery as it relates to rates has not played out; rates are still at historic lows and that has prompted companies to borrow cash and engage in this buyback activity,” says Lilja.
This ability to build exposure in one’s portfolio to companies engaged in significant stock buybacks is clearly beneficial. Although not an investment strategy that works year after year (what strategy is?), Lilja says that the Index does outperform the wider market for the majority of years, “which is in line with what we were expecting.”
At a time when investors are concerned with increasing volatility in equity markets, finding companies that announce and actually follow through with their stock buyback programs can provide a welcome buffer to stock price volatility. Lilja adds: “Just as putting a certain percentage of one’s portfolio allocation into companies that pay out dividends is important, so too is allocating to a certain number of companies that are buying back stock and actually reducing the number of shares outstanding in the market.”
From a sector perspective, the information technology sector is the biggest spender when it comes to share buybacks although this is skewed slightly by Apple because of their massive buyback program (USD6 billion in Q4 2015 alone).
Indeed, four of the 10 top companies in terms of dollars spent on buybacks come from the technology sector. In terms of growth, the number one sector is consumer discretionary.
Lilja believes that there is room for further growth in stock buybacks.
“When I wrote the first version of this paper in 2014 we had seen a record year for stock buybacks. At the time, I warned that with high stock prices it was possible if the economics stayed steady and stock markets continued to rise US companies might reduce their buyback programs and engage in riskier growth-related activities but that has yet to happen.
“While buybacks to date are not on track to exceed 2015 by dollars spent, it is still possible for 2016 to top 2015 simply because buybacks are increasing in popularity as more companies enter the fray,” concludes Lilja.
For more information, please contact Nasdaq Global Information Services
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