Wonderful Wednesday: The Benefits of Share Buybacks

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 22, 2019 3:24:43 PM

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share buybackI am starting a new feature on the blog: Wonderful Wednesday! Much of the commentary we see in the press—and certainly here—tends to focus on things that can go wrong and things we should worry about. You rarely see a story stating that everything is great.

That said, I don’t mean for this segment to be a cheering section. Instead, I would like to recognize that to provide a full view of what is happening in the economy and the markets, we have to acknowledge the good stuff, as well as the risks and the threats. This is particularly the case when some of the risks and threats actually include significant positive aspects, which brings us to today’s topic: share buybacks.

What is a share buyback?

Simply put, a share buyback is when a company buys back its own shares in the open market. These shares are effectively retired, meaning there are fewer shares outstanding. With fewer shares, the company profits must be divided up fewer ways, so each share gets a larger proportion. On a per-share basis, that means that earnings per share are higher. Plus, if the buybacks continue, earnings per share can grow faster than overall earnings. Higher earnings and faster growth typically mean higher share prices. As an investor, this is something I like.

In fact, buybacks have been at record levels for much of the past five years and have significantly upped earnings-per-share growth above what actual top-line earnings growth has been. According to Ned Davis Research, without buybacks, the S&P 500 would be almost 20 percent lower. In other words, a big chunk of the returns we have seen have been due to companies buying back their own stock.

Changing the narrative

Much of the narrative surrounding buybacks has been negative: Companies are not investing in the business. Financial engineering is not real growth. The pace of buybacks is unsustainable. And there are many more.

Note though that most of these worries relate to the company itself, rather than the stock. Although these are real concerns, as stockholders, we are most concerned with the stock itself. If the share of earnings that flow to each share goes up, so too should the share price. As management has a primary responsibility to shareholders, this is what they should be doing. In fact, some of the best managers out there, as outlined in The Outsiders, have done just that. As an investor, share buybacks are something we should cheer. When a company has no better use for its capital, buybacks can help both existing and future shareholders. Rather than using capital to finance ego-driven acquisitions, managers are actually working to enhance capital returns for investors.

There can, of course, be too much of a good thing, as is always the case. When a company is investing its earnings in its stock, that can be a positive. When a company is loading up on debt to buy its stock, that might be less favorable—or even dangerous. Like any strategy, we need to keep an eye on the risks and deploy the strategy in a balanced way.

Good for everyone

When responsibly used, however, buybacks are good for everyone—and a sign of responsible management. The fact that buybacks have indeed been a supporter of the market during this expansion, and may well continue to do so, is a good thing—and a prime candidate for the first wonderful Wednesday.

By the way, Eeyore has not left the building. Tomorrow we will do Threatening Thursday!

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