Stephen Antczak, Michael Anderson, and Jung Lee from Citi research postulate that companies buy more of their own shares when stock prices are rising. While this behavior seems to go against “buy low and sell high” market wisdom, company managers are seeking to enhance their share prices by engaging in shareholder-friendly activities like stock buybacks. The current environment of low interest rates and high cash levels in balance sheets is the backdrop for low company default rates. Antczak, Anderson, and Lee note that as default rates go down, share buybacks go up.
Some market participants, particularly value investors, may be skeptical about return on investment (ROI) on share buybacks. A 2012 corporate buyback scorecard compiled by Institutional Investor covering repurchases done from 2010 to 2012 suggests that more than half of share buybacks did not pass the 10% ROI hurdle that applies to other company investments. The worst performing sectors included technology and hardware. The worst performer of the list was Netflix, Inc. (NASDAQ:NFLX), which had to undo its share repurchases as it ran out of cash. The share buyback ROI for the firm was 51.9%.
Avoiding laggards by investing in buybacks with higher EPS potential
Antczak, Anderson, and Lee argue that earnings per share (EPS) must increase enough to offset the increase in default risk caused by share buybacks. Repurchases may use up cash or be financed by debt and such action may weaken the firm’s balance sheet. If EPS increases bolstered by favorable macroeconomic conditions, investing in companies doing buybacks may yield gains.
As companies’ default rates decrease, their chance of survival increases. Holding long term average price/earnings (P/E) multiples and long term EPS forecast constant, Citi analysts note that improved chance of survival helps support higher S&P 500 valuations.
In Citi’s view, it is easier to achieve positive returns from buybacks in a lower default rate environment. A higher default rate during 2010 may help explain why ROIs on buybacks tracked by Institutional Investor were less than 10% between 2010 and 2012.
Companies that continue to engage in share repurchasing with default rates at multi-year lows could continue to generate above market gains. A portfolio of 50 S&P 500 listed companies that bought at least 5% of their outstanding shares over the past 12 months has returned 12% more relative to the S&P 500. However, Citi analysts suggest buying some protection for some share buyback candidates as spreads do not have room to tighten much further and macroeconomic factors may deteriorate. Both scenarios could increase default rates making share repurchasing firms less attractive.