Corporate cash reserves have been swelling, as firms repatriated $665 billion back into the US in 2018 and corporate cash flows are hitting all-time highs, partly due to the reduced corporate tax rate.
Businesses have reviewed their possible cash allocation options and many are deciding that stock buybacks are the best choice for their investors. So far in Q1, over 80% of S&P 500 companies had reported stock repurchases this past quarter, with an overall repurchase of $180 billion worth of equity.
The question that we, as investors may have is, what implications does a stock buyback have on me and my positions? The answer is a little more ambiguous than you might think, but in this article, we will dive into the advantages and positive implications that stock repurchases could have. In a supplementary article, I will discuss the negatives of stock repurchase programs, but for this discussion we will focus on the positives.
What a Stock Repurchase Does for Investors
When a firm buys back its own stock off the public market the number of outstanding shares decreases meaning that the earnings per share would increase assuming no change in the company’s total profits, making each share worth more.
When a firm repurchases stock it usually does it in large blocks. When a large block of stock is purchased on the open market, the stock will uptick and continue to do so as the bids outweigh the offers. This has an initial upward push on the stock price.
Corporate Stock Repurchase Advantages
There are many reasons why a firm would decide to use its extra cash to repurchase stocks oppose to using this money to pay dividends or invest elsewhere.
Undervalued Stock Price
A growing company buying back large portions of its stock could indicate that management believes the stock is currently undervalued. As insiders management has the best insight into the future outlook of the business. Management could believe the company has a lot more growth potential than the market has priced in, or maybe they believe that the stock is oversold on adverse news. Investors and trades tend to look at short-term business outlooks, while management is viewing long-term potential.
If management believes that their stock is undervalued at any point in time, they may decide repurchase stock at this perceived low valuation. They have the option to re-issue the stock at a later date at an anticipated higher price for a capital gain.
Undervaluation is likely what drove the record number of stock buybacks in Q4 with $223 billion worth of outstanding shares being pulled off the market. Management saw that the fundamental outlook of their businesses had not changed and the large correction we saw at the end of last year was driven by forces outside the scope of their company’s performance. Corporate America bought back a record number of shares at a very opportune time with the entire market bouncing back and more in Q1.
The principle that investors typically hold about stock repurchase programs is that management only executes on these buybacks when they believe the stock is undervalued. As an investor we can benefit from this principle, looking for large stock repurchases as an indicator of an undervalued stock. Obviously this is not the “holy grail” for recognizing an undervalued stock, but along with an investor’s research and due diligence, this principle can be valuable.
Apple (AAPL - Free Report) had by far the most buybacks last year pulling $74.25 billion worth of its own stock off the market. Apple’s Board of Directors just authorized an additional $75 billion in stock repurchases making the total approved repurchase program $175 billion (of which $61.3 has been utilized). This may be a signal that management is very optimistic about the future of this growing business. You can see below how many shares AAPL has taken out of the market in the last 6 years.
Protect Stock Price
A public firm that uses its extra cash to buyback stocks instead of paying out dividends could be doing so to protect the long run price of their stock. If a firm pays a dividend to shareholders, the shareholders expect this dividend to grow with the company. If the dividend is cut when a firm is in need of cash, the stock is subject to a significant tumble.
You can see this in the case of General Electric (GE - Free Report) when they cut their dividend payout in half in November of 2017 and the stock dropped over 12% in a two day period.
If a public company opts to use stock buyback to compensate shareholders, they are not under the same scrutiny when cash flow is tight as they lighten the volume of stock repurchases. Investors wouldn’t see the same stock losses that a dividend cut would drive.
Reduce Cost of Capital
Mature firms might repurchase shares to reduce the long term cost of capital. If the firm is consistently paying out dividends to shareholders in an industry that doesn’t have much room for growth, then using its extra cash to reduce outside ownership and lessen the long-term dividend burden is a good use of free-cash-flow. Businesses that operate in mature industries don’t have many growth opportunities to invest its extra capital.
For example, the banking industry is very mature and the larger firms don’t have many investment avenues outside of their current operations. It would make sense that these firms should use their extra funds to reduce their long-run cost of capital.
In Q4 of 2018 the financial industry made up over 20% of the S&P 500’s total buybacks. Wells Fargo (WFC - Free Report) , Bank of America (BAC - Free Report) , and JPMorgan (JPM - Free Report) repurchased over $61 billion in its own stocks.
There are many reasons why a public firm would repurchase its stock whether it is to take advantage of its undervalued stock, protect its stock price or reduce a business’s long run cost of capital. The underlying theory behind buybacks remains that management will only execute these buys when they believe their stock is undervalued. There are exceptions to this that I will elaborate on in my next article, but this is the generally accepted theory. Stock buybacks can be added to the list of indicators you already use when deciding to invest in a stock.
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