Few topics have spawned more confusion and misinformation than share repurchases, or stock buybacks.
Many investors view buybacks as benign ways for companies to return cash to shareholders. Others see pernicious and toxic instruments of manipulation that enable top executives to enrich themselves at their workers’ and shareholders’ expense.
This debate would become a lot less polarized if both sides were to recognize that not all buybacks are created equal. A buyback signifies one thing when it is used to absorb the otherwise diluting effect of an options exercise by a company’s CEO — and especially if its timing is planned to hit the market just before that exercise.
In contrast, a buyback means quite another when the company’s board genuinely believes its stock is significantly undervalued.
I will leave to others the political and policy debate about buybacks. But from an investor’s perspective, the real issue is the net supply of a company’s shares. Other things equal, an increased supply dilutes a company’s earnings and is bad for shareholders, while a reduced supply is just the opposite.
Viewed in this way, investors shouldn’t focus exclusively on buybacks in isolation but on myriad factors that can change the total of a company’s outstanding shares. Stock and option grants that are part of an executive’s compensation will increase that total, for example, as will any secondary offering. Mergers and acquisitions will reduce market-wide supply.
One firm that pioneered this comprehensive focus is TrimTabs, now part of EPFR (a division of Informa Financial Intelligence). In as close to real time as possible, the firm calculates the net impact on market-wide share totals (“U.S. equity float”) of everything from share repurchases, mergers and acquisitions, to secondary offerings, convertible bond offering, and insider sales.
Winston Chua of TrimTabs’ media relations office said in an email that “the way you want to interpret these figures is that… decreases in float are bullish.” Notice that this bullish impact has nothing to do with the company’s motivation in repurchasing its shares—a cynical or manipulative motive will have the same impact over time as a genuine belief in its shares’ undervaluation.
So far in 2019, the U.S. stock market’s float has shrunk by more than $300 billion, according to Chua. If the float continues to shrink for the rest of the year at the same pace, the full year total will top $700 billion. As you can see from the chart below, that would put this year’s pace more or less in line with the previous five years’ average — below the individual year totals of 2015, 2016, and 2018, but above those of 2014 and 2017.
This is important information because some market commentators have worried that the pace of buybacks this year would shrink dramatically over last year’s blistering pace. But once we focus on all factors affecting the stock market’s share count, it’s evident that this isn’t a major concern.
The bullishness of a reduced equity float is supported by academic research. One prominent study was published last Fall in the Financial Analysts Journal entitled “Net Buybacks and the Seven Dwarfs,” conducted by three researchers from the Abu Dhabi Investment Authority.
These researchers use the phrase “net buybacks” to refer to what TrimTabs calls float. They found that net buybacks explain the bulk of the difference in different countries’ stock returns over the last several decades. This comes as a big surprise, since most of us would otherwise think that these return differences would be caused by different rates of economic growth. But the researchers found that net buybacks exerted a far bigger influence.
A related straw in the wind: the market-beating performance of an exchange-traded fund that invests in individual stocks that have experienced the biggest reduction in floats — the TrimTabs All Cap US Free-Cash-Flow ETF
To be sure, this fund only began trading in September 2016, so its track record is more suggestive than conclusive. Still, it’s encouraging that since its inception the ETF has beaten the S&P 500’s
total return by 1.9 annualized percentage points.
The bottom line? Don’t let the polarized debate about buybacks cloud your investment judgment. Your focus should be on all factors that increase or reduce a company’s or the overall market’s share count. Buybacks are just one such factor of many.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. Hulbert can be reached at email@example.com