Why Stock Market Buybacks Should Make Investors Nervous

RYAN DEROUSSEAU  | April 20, 2018 | Read Article

We’re more than nine years into a bull market, and it’s no secret that stocks are expensive. The Shiller price/earnings ratio, which compares companies’ share prices with their inflation-adjusted 10-year earnings average, is at 31, well above the historical median of 16—a sign that future returns will be sluggish. Combine that with simmering worries about trade wars and inflation, and you get a climate in which fewer investors are clicking the “buy” button.

Yet there’s one group purchasing company shares with gusto: the companies themselves. As the impact of new tax cuts circulates through corporate balance sheets, businesses are getting an infusion of cash, and much of the windfall is going toward buying back stock. J.P. Morgan estimates that repurchases in 2018 will jump 51% from last year’s mark, to $800 billion, which would be a single-
year record.

That’s the theory, anyway. But for many companies, it hasn’t quite worked out that way, says Gregory Milano, CEO of financial consultancy Fortuna Advisors. Since 2011, Fortuna has calculated a “buyback ROI,” or return on investment, which tracks post-buyback stock prices and other data points to measure the effectiveness of corporate repurchases. And 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%.

Fortuna Advisors, a financial consulting firm that compiles a buyback scorecard, has a particularly sobering assessment of the strategy’s effectiveness. (To see one of Fortuna’s most recent buyback reports, click here.)

How to confront this conundrum?

With stocks in general still trading so high, investors are best off ignoring the short-term hype around buyback announcements and instead taking a closer look at companies on repurchasing binges to see if their share prices have more room to run. Here are three that fit the bill.

Boeing has been feeling turbulence from the tariff battle between President Trump and China: About 25% of Boeing’s airplanes go to Chinese buyers. But the benefits of recent tax cuts may more than offset any trade damage. One vignette of the tax impact: When developing the 787, Boeing wrote off the expense at the then-prevailing 35% tax rate; now that it’s selling the planes, it owes tax of only 21% on the profits. Boeing recently announced an $18 billion repurchase program, and thanks to a thriving airplane market, there’s a “buying environment” for the stock, says Cowen analyst Cai von Rumohr.

At today’s prices, investors may want to simply stay out of the repurchasing game. One company that has done the same: Charles Schwab, which hasn’t done a buyback since the Great Recession. As its balance sheet recovered, Schwab reinvested heavily in technology and in its consumer bank, Schwab Bank—which has gone from $49 billion in assets in 2010 to $199 billion today. It now accounts for nearly half the company’s revenue, and it generates income more predictably than Schwab’s commission-heavy businesses, like its self-directed brokerage, says Steven Chubak, an analyst at Nomura Instinet. The financial sector paid out $124 billion in repurchases in 2017, but Schwab has no plans to join that parade this year.

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