With debate raging as to whether the nine-year bull market is coming to an end or merely taking a rest, the reality is that stock valuations are a little bit high.
According to research-firm FactSet, as of May 2018, the forward 12-month P/E ratio for the S&P 500 is 16.5. This P/E ratio is above the 5-year average of 16.1 and above the 10-year average of 14.3.
Layer on top of that the geopolitical tensions with China and North Korea, rising inflation and rising interest rates, it’s no wonder that your average investor might not be too keen on buying stocks right now. But there is one group buying stock at a very healthy clip: companies themselves – and they’re buying their own shares through stock buybacks. Is the increased activity of stock buybacks a good indicator for the markets? Or the result of something else? Let’s examine.
Buybacks Used to Be Illegal
Most investors probably don’t realize this, but stock buybacks were illegal until the early 1980s. Up until that time, the Securities and Exchange Commission considered stock buybacks to be a form of stock market manipulation. And in case you forgot, the SEC’s stated mission has been pretty clear since it was founded in 1934:
“The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”
Nonetheless, in 1982, the SEC passed a rule creating a legal process for buybacks and companies started doing so in droves.
Buybacks Are Big and Getting Bigger
Market research firm Birinyi Associates has kept track of $9.9 trillion in stock buyback announcements since 1984. And since 2008, $5.6 trillion in buybacks have been announced.
But 2018 is shaping up to be even bigger. So far this year, there have been $201 billion in buyback announcements and estimates peg the final 2018 number to come in around $800 billion – dramatically up from $530 billion in 2017 and well above 2007’s all-time high water mark of almost $700 billion.
Are Buybacks Good or Bad?
Interestingly, there is a ton of debate and a lot of solid research about whether buybacks are good or bad, but rather than try to answer that question, maybe we should just lay out the arguments.
Advocates of buybacks note that with companies investing in their own business and with money going back into the “markets,” then this causes consumer confidence to rise, consumer consumption to rise, and then stock prices to rise. Since buybacks reduce the number of shares outstanding, this will give each remaining shareholder a bigger share of future company profits, making stock prices rise. Well, that’s the theory.
According to JP Morgan, since 2000, stocks with higher buyback yields (i.e., spending on buybacks divided by market capitalization) outperformed their rivals by 1.5% during market corrections and by 2% during recessions.
Critics of buybacks on the other hand suggest that buybacks simply result in corporations giving money to their shareholders instead of investing in something more productive and broadly beneficial to their long-term success.
And there is additional research that counters JP Morgan’s conclusions with conflicting data. For the past 7 years, financial consultancy firm Fortuna has tracked post-buyback stock prices and created a “buyback ROI.” Accoring to their research, over the five years through 2017, the 353 companies that spent significantly on buybacks underperformed the market on average. Their median ROI was 13.8% annually, including dividends, while the S&P 500’s return was 15.8%.
Because of the New Tax Bill?
Since the enactment of the Tax Cuts and Jobs Act of 2017, companies are quickly buying back their own shares. In fact, share buybacks in 2018 have averaged $4.8 billion per day, double the pace from the same period last year. And economists predict that a company’s ability to bring back cash that was overseas and pay lower taxes will continue to fuel stock buyback announcements to record levels.
In fact, there are estimates that the S&P 500 companies have $1.67 trillion in overseas cash, with more than 60% of overseas cash held by technology companies (next are health care and then industrial companies).
For example, tech giant Cisco, which reported that it held more $70 billion cash overseas prior to the tax cut, announced in February that it would bring some of that money back and use $25 billion toward a stock buyback program. Others announcing large stock buybacks include Boeing ($14b), Merck ($10b) and Oracle ($10b).
And let’s not forget Apple’s announcement to return another $100 billion to shareholders via buybacks. In fact, Apple already spent $23.5 billion in buybacks in the first quarter of 2018, which is the biggest quarterly buyback in U.S. history. But consider this:
Apple’s $23.5 billion buyback over the first 3 months of 2018 is greater than the market value of 275 companies in the S&P 500. Yikes.
Final Thoughts from a Financial Advisor
With stocks generally trading above their historical averages, investors would be well served by ignoring any short-term noise about buyback announcements and should instead focus on a company’s fundamentals.
Like all financial decisions, the more we research and the further out we plan your trip, the more successful your journey. I look forward to discussing your thoughts and helping you plan for your future.
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