Financial statement analysis is often useful for valuing a company’s stock. Using ratios such as price-to-earnings, price-to-sales or price-to-book, investors assess whether a stock is trading at a discount to its intrinsic value.
However, these ratios aren’t the only way to assess a stock’s value. I believe that share buybacks can be another helpful tool — when a company’s management team reduces the number of shares outstanding, it is signaling to the market that a stock is trading inexpensively to its intrinsic value.
Of course, as with any strategy, it’s important to understand the performance drivers of buyback strategies, so that you can anticipate when they may be poised to outperform or underperform. And the drivers of buyback strategy performance may be surprising to some investors.
How are share buybacks different from traditional valuation measures?
Related: Compelling Valuations Aren’t That Hidden
A management team’s assessment of a stock’s value has certain advantages over traditional financial statement analysis, in my view. Typically, management has a strong command of the prevailing competitive landscape, economic backdrop and industry trends affecting the firm.
Because management has an information advantage, the decision to repurchase shares often implies that management sees the return potential from buying stock as advantageous to other uses of cash. In effect, management is telling investors that the stock is cheap. By extension, a buyback investment strategy assumes that management is reducing share count for good reason, which can prompt value investors to take action.
The relationship between shares outstanding and earnings per share
A reduction in shares outstanding spreads profits over a smaller base, which tends to increase a company’s earnings per share — an important measure of profitability. Assuming a constant valuation multiple and no change in earnings, rising earnings per share can support equity prices, as stock prices tend to move in the direction of earnings and profits over time.
Not all share buybacks are the same: Macroeconomic influences
Certain macro conditions favor buyback activity, as I’ll explain further below. For example, falling or low interest rates allow a company to borrow cheaply and repurchase its shares with the proceeds. Likewise, a slow economy that presents limited investment opportunities creates fewer investment options — increasing the likelihood of a share repurchase program.
However, these conditions can sometimes cause investors to get too excited about a buyback theme, and they tend to expect outperformance during these environments. While economic conditions may affect the number of companies repurchasing shares, they don’t necessarily lead to higher returns for a buyback strategy.
To illustrate this, consider the NASDAQ US Buyback Achievers Index, which selects stocks that have experienced a net reduction in shares outstanding of 5% or more over the trailing 12 months. In other words, the index includes companies that have been repurchasing shares. In the chart below, note that the number of companies included in the index was relatively high in 2008 and 2009 and low in 2010 and 2011, but the relationship between share buyback participation and excess returns was limited.
As you can see, the economic conditions that accompany different points in time may influence the number of companies buying back shares, but not necessarily the returns of a buyback strategy.
The effect of interest rates on buyback activity
One of the factors that can affect buyback activity is interest rates. In the chart below, note the inverse linear relationship between the change in interest rates, as represented by the 10-year US Treasury bond, and the corresponding number of companies in the NASDAQ US Buyback Achievers Index.
Falling rates can make it cheaper to repurchase shares, while rising rates can make it more expensive to do so, creating the downward-sloping trend line in the graphic. During this time, the change in rates explained about 53% of the variation in the number of holdings in the NASDAQ US Buyback Achievers Index.
The effect of investment activity on buyback activity
When companies spend less on plant and equipment, they may have more capital available to repurchase shares. Alternatively, repurchasing shares may also indicate that buying back stock is more attractive than an investment in plant or equipment.
The graphic below displays the relationship between the year-over-year change in nonresidential investment spending and the number of stocks in the NASDAQ US Buyback Achievers index. Note that periods of slumping investment experienced a pickup in the number of companies buying back shares, while periods of rising investment produced just the opposite. During this time, the growth of investment spending explained about 71% of the variation in holdings in the index.
So why did buyback lag in 2014 and 2015?
Buyback as an investment strategy lagged in 2014 and 2015. I believe this was primarily because of market conditions. The NASDAQ US Buyback Achievers Index tilts toward the value and small-size factors because buyback is a form of value investing, while the companies meeting the buyback threshold of 5% tend to be less concentrated in size than a market-cap-based index like the S&P 500 Index. As the table below indicates, during years in which buyback underperformed, value (represented by the S&P 500 Pure Value Index) and/or small-size (represented by the S&P MidCap 400 Index) were out of favor.
Considering what I’ve outlined above, I believe buyback investors should stay focused on stock buybacks as a signal of value, but should also be aware of the economic backdrop. Buyback strategies may potentially do well when the value and small-size factors are in favor, but can’t necessarily be expected to outperform during periods of low interest rates or slow investment activity, when companies are more likely to execute buybacks.
Investors interested in buyback strategy should explore the PowerShares BuyBack Achievers Portfolio (PKW) or the PowerShares International BuyBack Achievers Portfolio (IPKW).