The Power of Stock Buybacks

As a Louisiana native, I love Mardi Gras season. The festivities don’t culminate until Fat Tuesday, which falls on February 13 this year. So we’ve got one more week of king cakes and carnival revelry.

Of course, New Orleans is home to the most raucous and boisterous parade celebrations. But most of the major cities get in on the fun.

In my hometown, the Krewe of Centaur and Gemini parades welcome more than 200,000 eager visitors each year, generating an economic impact of nearly $20 million. Years ago, city planners started cordoning off part of the five-mile parade route for private, reserved spots (most of which are renewed annually or placed into a lottery).

Like everything else, the cost of these private tailgate and bead-catching sections has escalated quite a bit over the years. Even worse, the lines dividing one spot from the next seem to keep getting redrawn a bit closer each year.

It’s simple math: At 20 lateral feet of street frontage per spot, the city can sell 264 parade “leases” along a one-mile stretch (5,280ft/20ft). But carve this same street into thinner 18-foot sections and you can squeeze in 293. And at 15 feet, the city can collect 352 rental fees.

That’s about 90 more people with an equal pro-rata claim on the available real estate. And the streets aren’t getting any longer.

So each new permit holder means existing spot-holders must crowd just a little bit closer together. As I cram chairs, coolers, and other belongings into our pre-designated area, I always get a real-life reminder about the dilutive impact of stock issuance.

You see, the ownership of publicly traded companies is also divvied up into an allotted number of shares. And every time new shares are issued, each sliver gets a little bit smaller. Its proportional claim on the company’s assets and earnings shrinks — so all else equal, the shares are worth less.

If a billion-dollar company is divided into a billion shares, they are naturally worth $1 apiece. But if the pie is carved into, say, another hundred million slices… well, you can do the math.

Fortunately, the reverse is also true. Whenever a company repurchases shares, the remaining “claims” get a little bit bigger — and more valuable.

The Power of Buybacks

It’s not easy to get the keys to the executive lounge at a Fortune 500 company. Those who rise to the rank of chief executive officer (CEO) or chief financial officer (CFO) have years of experience and top-notch credentials. Usually, only the best and brightest get to steer America’s largest corporations.

You aren’t appointed to this position without knowing a thing or two about how to allocate excess cash to optimize returns. And where are these captains of industry putting all that cash?

Well, S&P 500 companies will plow about $480 billion into research and development (R&D) activity this year to spur new product innovation. And they will invest twice that much in capital expenditures (capex) to build and upgrade physical assets.

After a lull in 2023, I’m expecting a sharp rebound in merger and acquisition (M&A) deal volume.

And let’s not forget about dividend distributions — which are expected to climb for the 15th straight year to $617 billion.

But the single biggest block of cash — $840 billion — will be reserved for share repurchases. That breaks down to a staggering $2.3 billion per day. And it still trails the record of $923 billion in aggregate buybacks in 2022.

Two decades ago, less than half (40%) of S&P companies participated in stock buybacks. But that percentage has more than doubled over the years. According to S&P, 428 members of the S&P 500 (85%) have conducted stock buybacks over the past 12 months.

The financial wizards at these 428 companies are all saying the same thing: Stock buybacks work.

Nearly nine in 10 major companies believe that share repurchases create value for stockholders. That’s about the closest you can come in the investment world to a consensus.

Since the financial crisis in 2008, this has been the lever most often pulled to enhance returns. Bank of America estimates that of every dollar of incremental corporate revenue or borrowing, 24 cents have been funneled into stock buybacks.

Of course, I always have to insert the standard caveat here. Buybacks make economic sense only if the stock in question is trading below its intrinsic value. When companies overpay and repurchase stock for more than it’s really worth, shareholder value is ultimately destroyed, not created.

There is little financial sense in purchasing dollar bills for $1.10 (even if doing so temporarily props up stock prices in the short term).

When buybacks are done for the right reasons, I fully agree with Warren Buffett, who believes that “enlarging the interests of owners is by far the most attractive option for capital utilization.”

As you probably know, this practice is loathed by left-leaning politicians, who managed to slip a 1% excise tax on stock buybacks inside the Inflation Reduction Act. But it hasn’t been much of a deterrent.

Apple (NSDQ: AAPL) is a poster child, pouring nearly $80 billion into stock buybacks last year.

Source: YCharts

That didn’t come at the expense of anything else. The tech giant still sunk $10 billion into new plants and equipment, shelled out $15 billion in dividends, and invested $30 billion into research and development to maintain its competitive edge.

It also made strategic acquisitions to expand into new arenas, such as augmented reality headsets.

When you haul in $114 billion in yearly operating profits (with a mountain of retained cash on the books), you can spread it around. But buybacks are clearly a top priority.

Apple has repurchased and retired 379 million shares over the past 12 months. So the $3.9 billion (13%) increase in net income last quarter was magnified even more on a per-share basis. Fewer slices of a growing pie.

The impact doesn’t benefit just CEO Tim Cook, but most of the firm’s 164,000 rank-and-file workers and millions of individual stockholders across the country.

Buybacks = Outperformance

Of course, Apple is just one example. Credit Suisse has crunched some numbers and determined that buybacks added nearly 4% to S&P 500 earnings per share (EPS) growth last quarter — a sizeable contribution.

Studies conducted by Bloomberg (among others) reveal some compelling findings. Over the long haul, companies that return more profit to shareholders through buybacks tend to outperform stingier companies and the market as a whole.

Between 1982 and 2011, the top quartile of stocks in the S&P 500 ranked by buyback yield (net buyback expenditures as a percentage of market cap) generated annualized gains of 13.19%, versus 10.96% for the S&P 500.

On a $100,000 portfolio, that excess return would put an additional $17,596 in your pocket over a 10-year period.

That outperformance is even more exaggerated in environments like this when the economy is tepid and earnings growth stalls.

Beware, many companies repurchase five shares with one hand and print four new ones with the other. That’s a bit like driving with one foot on the gas and the other on the brake. It’s the net buybacks (not gross) that matter.

This is particularly common in industries where stock options are a favored form of employee compensation and repurchases are only meant to offset dilution. Even with all those billions spent, the share count never really seems to drop — and often continues to slowly rise.