Not All Share Buyback Programs Created Equal

By George Leong

While you can’t tell, judging by the growth the S&P 500 has experienced this year, most companies on the index aren’t doing all that well. Somehow, against a backdrop of high unemployment and stagnant wages, the index has managed to chalk up a 26% year-to-date gain.

Not only has it managed to hit new highs week after week, it has done so after an increasingly large number of companies warned about revenues and earnings. For example, during the first quarter of 2013, 78% of S&P 500 companies issued negative EPS guidance; during the second quarter, 81% of companies issued negative guidance; and in the third quarter, a record 83% of all S&P 500 companies revised their third-quarter earnings guidance lower. So far, 89 of the S&P 500 companies, or 88%, have already issued negative earnings guidance for the fourth quarter. (Source: FactSet, last accessed November 25, 2013.)

What David Copperfield tricks have these companies employed to mask their weak results? Companies looking to impress their shareholders are, by and large, implementing extraordinary share buyback programs, propping up corporate earnings and masking negative growth.

It’s hard to figure out how the S&P 500 can advance as much as it has during a year where companies are missing on revenues and earnings are, when you factor in share buyback programs, flat.

On top of that, many firms use share buyback programs to simply extinguish option grants, which doesn’t move the overall share count at all.

Not all share buyback programs are being used to artificially prop up results. In fact, a large number of honest S&P 500 companies with strong fundamentals are using share buyback programs to legitimately cannibalize their overall share count.

Not surprisingly, there’s an index that follows that. Rebalanced quarterly, the S&P 500 Buyback Index measures the top 100 stocks in the index with the highest buyback ratios. Over the last decade, it has outperformed the S&P 500 by about four percent year-over-year.

This year’s results, however, have been spectacular. Whereas the S&P 500 is up 26% year-to-date, the S&P 500 Buyback Index is up 40%. Over the last 12 months, the S&P 500 has climbed an impressive 29.5%; over that same time period, however, the S&P 500 Buyback Index is up an eye-watering 44.5%!

Not all share buybacks are created equal. When it comes to pleasing shareholders, share buyback programs are all about timing, both good and bad. Companies that repurchase shares just to prop up their earnings might be paying more for their shares than they’re intrinsically worth, meaning they’re forking out $1.00 for a share worth $0.80. It’s pretty difficult to build long-term investor wealth when you’re doing that.

It’s also difficult to keep the share buyback spigot flowing when share prices are increasing. When share prices rise, companies need to spend more on share buybacks just to repurchase the same number of shares.

If, however, a company is spending $0.75 to purchase shares worth $1.00, that’s a different story. But in this climate, it’s rare, especially when you consider that irrational investors are sending companies with mediocre fundamentals higher and higher every day.

But they’re out there. It’s not entirely difficult in this economic environment to tell which companies on the S&P 500 Buyback Index are most likely using share buybacks to strengthen their bottom line or marionette strings to tow investors along.

A little due diligence will shine a spotlight on the winners.

This article Not All Share Buyback Programs Created Equal was originally published at Daily Gains Letter