stock market

How The Market’s Biggest Buyers Lifted Stocks To Record Highs

Editor’s note: Originally published on January 21 2015.

Over the past few years, the stock market has risen from the depths of the financial crisis, experiencing a steady bull market. If you look at the major indexes today, many are near record levels, leading many observers to ask what or who is driving this recent surge in demand for stocks. It turns out, the biggest buyers have been the listed companies themselves – and they are buying back stock at a record pace.

The rise in the markets has left many companies sitting on cash, searching for ways to deploy it. One option is to invest in growth opportunities such as R&D and acquisition activity. Another is to return the cash to shareholders via a dividend payment or stock buyback program. In the post-crisis economic environment, which has offered bouts of uncertainty, companies have increasingly chosen to return their cash to shareholders in lieu of investing in riskier growth-related activities.

A stock buyback, or share repurchase, occurs when a company purchases shares of its own stock, thereby reducing the number of shares outstanding. A company typically uses cash to fund the purchase, though the purchase can also be financed.

Companies start the buyback process by announcing to the SEC and the public they plan to repurchase shares. The company typically discloses how much stock it intends to repurchase and a timeline. The SEC has rules in place to ensure fair trading, including a volume limitation that prohibits a company from purchasing more than 25% of its average daily volume on any given day.

A buyback is only one of many transactions that a company can execute on its stock. At the same time that it is repurchasing shares, a company may also be issuing new shares via employee equity grants or stock options. It is often the case that buyback programs are instituted to specifically offset new stock issuance. As a result, it is possible for a company to repurchase shares, but actually increase its total shares outstanding.

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Share repurchase plans have been increasing in dollar amount over the past few years. In 2013, S&P 500 companies spent $ 478 billion on share repurchases, a 24% increase over 2012, according to Factset Buyback Quarterly. For 2014, Bloomberg reports that S&P 500 companies are on pace to spend $ 565 billion on buybacks, topping both years. Major U.S. companies that have announced or expanded an existing buyback program this year include Apple (NASDAQ:AAPL), which expanded its $ 60 billion buyback to $ 90 billion, and Ford (NYSE:F), which announced a $ 1.8B buyback.

Despite a large dollar amount spent on buybacks, some companies only saw a small decrease in shares outstanding. This can be the result of two factors. First, the size of the company can mask the effect of a share buyback. Exxon Mobil (NYSE:XOM) spent almost $ 4 billion on share buybacks in Q1-14, but with a market capitalization of over $ 400 billion, the result of the buyback was less than a 1% decrease in shares outstanding for the quarter. Second, as mentioned before, the issuance of new shares can offset the effect of a buyback.

When a company announces or executes a share buyback, excess returns to the stock price can be attributed to a combination of fundamental and psychological factors.

A share buyback reduces the number of shares outstanding. Other things equal, this can increase the earnings per share growth rate for a company. In its simplest form, a reduction in shares outstanding has a direct inverse relationship to earnings per share. At a constant price/earnings ratio, this will drive the stock price higher. Share repurchases at prices below a company’s book value per share will have the effect of increasing that valuation measure. Repurchases also provide higher net share demand due to the reduction in shares outstanding, creating price support.

The announcement and implementation of a buyback can also have a positive effect on investor confidence. Buybacks are seen as an indication that management has faith in the company and that it believes the stock may be “cheap” at the current price.

In addition, a share buyback announcement and the implementation of a buyback program tend to be met with positive price performance. U.S. firms that authorized and announced share repurchase programs have outperformed the general market following the buyback announcement, a trend that has held true for the past nine years.

Companies that have executed buyback programs also put themselves in position to join specific indexes that track buyback companies, which in turn leads to their inclusion in ETFs. Investors seeking to invest in a broad array of buyback companies can now invest in several ETFs that track various buyback indexes. Given the growing number of indexes in this space, investors need to examine the methodology for each.

For example, the Nasdaq U.S. Buyback Achievers Index, launched in December 2006, is constructed to include U.S. corporations that have reduced the number of shares outstanding via buyback programs. In order to be eligible for inclusion in the index, a company must achieve a net reduction in shares outstanding of 5% or more in the trailing 12 month period. The index currently has 169 components with a market capitalization of over $ 2 trillion.

Once an investor determines the right approach, the next step is to invest in an ETF that tracks that particular index. In this case, the PowerShares Buyback Achievers ETF (NYSEARCA:PKW) tracks the Nasdaq U.S. Buyback Achievers Index, and has over $ 2.5 billion in assets.

With the markets moving toward record levels, it will be interesting to see how this all plays out, especially if a market correction occurs. Will companies continue to buy back stock at a record rate or will they turn back to growth-related investment options? Only time will tell.

Cameron Lilja contributed to the research for this article.

Editor’s Note: This article covers one or more stocks trading at less than $ 1 per share and/or with less than a $ 100 million market cap. Please be aware of the risks associated with these stocks.

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