Market Higher in 2007: The Underlying Bid from Stock Buybacks

Since investing is about risk and reward, one must always ask a key question?

Is there an underlying bid for stocks?

The current answer is a resounding "Yes".  The bid comes from corporate stock buybacks and private equity.  It does not yet include individual or foreign investors.  This article focuses on buybacks.

Background

Pretend for a moment that you are an executive at a major corporation that is enjoying fantastic profit growth.  You are faced with four choices for your cash:

1. Reinvest in growth -- research, development, or new equipment.
2. Retain cash, building up the balance sheet.
3. Increase the dividend.
4. Buy back stock.

Corporations choose among these alternatives based upon their own assessment of opportunities and rewarding investors.  Whatever they do may be second-guessed by Street analysts, most of whom have never met a payroll, who claim to know the best decision.

Retaining cash may preserve the opportunity for future investment or acquisition, or it might be a cushion for weaker prospects.

Increasing dividends is a long-term commitment to a higher return of earnings.  Companies do not take this action lightly, since they hate to reduce dividends if circumstances change.

Buying back stock provides an alternative payoff for investors.  As a result, each investor owns a larger share of future earnings.

Investor Preferences

Some investors want dividends, buying stocks with big yields.  Some funds will only buy stocks that pay dividends.  Other investors seek capital gains.  For these investors, buying in stock is quite attractive.

Investor preferences are often driven by tax consequences.  Buying back stock generates capital gains while dividends create income.  The (temporary?) tax reductions on dividends equalize this picture, but some individual preferences still favor capital gains.

In the mid 90's many valuation models that were based upon dividend yield completely broke down.  We experimented with these models, but abandoned them in the face of an obvious trend.  Corporations realized that many investors preferred capital gains taxation to dividend taxation.  Investors were "voting with their feet."

The Significance

The stock buyback trend has become so important that it now exceeds dividends in the payoff for the investor.  Standard & Poors shows that the tipping point for this trend was in 2004, with the buyback impact now about twice as important as dividends.

For those interested in the prospects for equities -- asset allocation, the most important decision and most common mistake -- the support of stock buybacks is crucial.  Please note that the existence and significance is a fact, and an important element of the current market rally.  There is no sign that it is stopping.  Strong corporate balance sheets, built through several years of double-digit profit gains, suggest that the trend can endure.

Writing for RealMoney last November, James Altucher put is as follows:

I really disagree with the notion that share buybacks are bad for a company. I think, in this day and age when private equity firms and S&P 500 companies have more cash than ever, we'll be seeing the supply of shares slowly being taken out of the market over the next few years. You can argue it's because they have no better use for the cash. But the real reason is that profits and margins are at all-time highs because of increases in productivity and the companies just plain and simply don't need the cash. So why not give it back to us?

A prescient comment from Altucher.

The Naysayers

There is a lot of commentary on buybacks from pundits who have been wrong about the stock market for a time period now measured in years.  The complaints include the following points:

• If companies were really confident, they would pay higher dividends (a micro decision);
• Some buybacks merely cover option grants (sometimes true, worth watching at a micro level);
• Many investors would prefer higher dividends (investors have a choice here);
• Companies are buying stock merely to inflate the stock price (this is what we want, so do we know the true value of the company better than the insiders?);
• This cannot go on forever (but it can go on for a long time).

Conclusion

The Naysayers sound like debaters who are losing on the macro facts.  They then make company-level assertions that the decisions are unwise or unsound.  In my reading of these comments it is never accompanied by a quantitative analysis.  It is second-guessing of corporate management by people who have no experience running a company.

On a company- specific level, the investor should do homework and decide about the company.  On the question of market valuation, these arguments are hollow.

The "poster-company" for buybacks is IBM.  Some bearish analysts choose to talk about what IBM earnings would be if they had not engaged in buybacks.  Who cares?  That was their choice, and investors should look at the capital structure of the company as it now stands.  Where does that leave the current IBM shareholder?

Take a look at the recent upgrade of IBM by Goldman Sachs to see the real market effect.  Take this case and start multiplying.....