Are Share Buy-backs good or bad for investors?

Share Buybacks have been a very popular use of corporate profits in the past few years. By some estimates, they have “artificially” increased earnings per share by over 25 per cent in the past few years. This would suggest that if we factor in non-adjusted EPS, and the value of share buybacks, the market is currently more expensive than in 1987 on an apples to apples P/E basis and perhaps a bit irrationally exuberant.

There is a great article from industry consultant McKinsey&Company that we took some examples from to illustrate the impact to earnings per share. The intuitive analysis suggests that increasing earnings per share results in higher share prices, but this belief is wrong, according to McKinsey.

“Buybacks aren’t without value. It is crucial, however, for managers and directors to understand their real effects when deciding to return cash to shareholders or to pursue other investment options. A buyback’s impact on share price comes from changes in a company’s capital structure and, more critically, from the signals a buyback sends. Investors are generally relieved to learn that companies don’t intend to do something wasteful—such as make an unwise acquisition or a poor capital expenditure—with the excess cash.”

McKinsey suggests the positive stock reaction generally seen is about the signal the message sends to shareholders. 1) executives see the stock as undervalued; 2) executives confident the company does not need cash to fund future obligations or capital expenditures; and 3) negatively that the company does not see any business growth opportunities and therefore need to boost earnings.

Overall, investors seem relieved that the best investment opportunity management sees is the value of their own shares. It would seem then if companies are buying back shares with a high valuation, it could be a poor use of capital. The long-term chart of S&P 500 buyback index shows some very notable trends. Prior to the tech bubble bursting in 2000 that was ushering in a generation of zero interest rates, there was no meaningful difference between share buybacks and non-buyback companies. But since interest rates have basically been zero, the boost to companies buying back stock has been enormous. Rising interest rates, however, is a major headwind to this strategy as cost of capital goes up. Once the Fed raised rates from 2004-2007, this group of companies did not outperform. We notice a similar trend in the past few years since the Fed has pulled back on their QE efforts.

In the past few years, there have been some ETFs that allow investors to access groups of stocks that have higher buybacks. PKW has been around since 2007 and has 1.6B the other two have been around about a year or less and have not picked up much investor interest possibly because they have generally been underperforming other index strategies.

http://www.bnn.ca/…/Larry-Berman-Benefits-and-risks-of-shar…

Share your thoughts and comments