Investing

Stock buybacks could go up this year, analysts say: What they are and what they mean for your portfolio

"Years with lean earnings or revenues can be improved through aggressive buybacks."

Share
Twenty/20

With large portions of the economy partially or totally shut down for much of 2020, businesses were forced to rethink how they spent the cash they had on hand. Spending among companies in the S&P 500 fell by 9% last year, and depending on which stocks they held, many investors saw the effects of that decrease on their portfolios.

One way companies cut back: distributing less of their profits to shareholders. Dividend payments, companies' most direct way of returning excess cash to shareholders, fell by about 1% in 2020. And buybacks, when companies spend money to repurchase shares of their own stock, fell by 30%.

With corporate spending set to bounce back in 2021 as the economy opens back up, analysts at Goldman Sachs are anticipating a 15% bump in buybacks.

What does that mean for you? It depends. If a company whose stock you are tracking announces a buyback, whether you should be happy about the news depends on the business's financial status — think earnings, debt, and cash flows — and the timing of when the buyback is announced.

Read on for more about what to look out for.

Why companies buy their own stock

Like dividends, buybacks are touted by corporate executives as a way to return excess cash to shareholders. But instead of distributing a direct cash payment, companies buy shares of their own stock on the open market. By reducing the total number of outstanding shares, each share that an investor owns represents a bigger piece of the overall company pie.

A buyback also boosts a key metric for a stock: earnings per share. With fewer shares on the market, the company's earnings look better on a per-share basis. Assuming a company's stock price remains constant, a large buyback drives down a stock's price-to-earnings ratio, making the stock more attractive to investors.

"We know that, short term, an announcement of a buyback supports the stock," says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. "If a company makes a big announcement, the stock is going to go up."

Companies that have consistently bought back stock have done well over the long run, too. During the past decade, the S&P 500 Buyback Index, which tracks the 100 stocks in the S&P 500 buying back the most shares, posted an annualized return of 12.6%. The S&P 500 returned 11.6% over the same period.

The controversy surrounding stock buybacks

Not everyone thinks buybacks are a great deal. In early 2019, following a then-record year for buybacks, Senators Chuck Schumer and Bernie Sanders wrote a New York Times op-ed calling for legislation that would ban companies from executing buybacks unless they met certain conditions for their workers, such as paying a $15 minimum wage and providing paid sick leave.

Buybacks, the lawmakers argued, disproportionately benefited major shareholders at the expense of workers and came in lieu of more productive uses for the money, such as spending on research and development. When Congress passed the CARES Act coronavirus relief bill in March, it included a provision barring bailed-out companies from using government-issued funds to purchase their own shares for 12 months after receiving the money.

VIDEO3:2603:26
How buying stocks has changed over the centuries

Video by David Fang

Not every buyback should be viewed as a benefit to shareholders, though, says Sam Stovall, managing director of U.S. equity strategy at CFRA. Sometimes a buyback merely offsets stock options taken by the corporate brass, or serves to artificially boost a stock's performance.

"Companies need to buy back shares when they offer options to executives so as not to dilute shares outstanding," he says. "At the same time, it can be a little bit of smoke and mirrors. Years with lean earnings or revenues can be improved through aggressive buybacks."

What to expect when a company announces a buyback

In general, investors don't take an announcement of a buyback program as seriously as, say, a company announcing an increase to its dividend. "A buyback might help support a stock's share price," says Stovall. "A dividend is a true reward that you can spend or invest."

If a company doesn't end up going through with the announced buyback, there won't necessarily be negative repercussions. "Investors tend not to care," says Stovall. Abandoning a buyback program "shows a company can stand on its own two feet and has found other ways to deploy the cash."

VIDEO2:3402:34
What are dividends and why some companies don't offer them

Video by Jason Armesto

Companies often ditch announced plans to buy back shares if management decides the money would be better spent elsewhere, say, on an acquisition. If they're right, that could be beneficial to the stock, but it also means you won't see the decrease in shares outstanding that you were anticipating if you purchased when the buyback was announced.

Generally, says Silverblatt, buybacks are good news when announced by companies who have otherwise healthy fundamentals, such as improving earnings and growing cash flows. "If I'm able to spend money every year on buybacks, it probably means that I'm doing pretty well," he says. "It's like if I drive a Mercedes or a Cadillac. I'm doing well, therefore I can afford a luxury car."

But be careful if companies are buying back shares with money they don't have. "If a company is taking on significant debt to fund the buybacks, that could put the company in a precarious position if there's a market pullback," says David Sekera, chief U.S. market strategist for Morningstar.

Generally, he says, you want to see a company buying back shares when the stock is trading cheaply. "We think buybacks can be an appropriate use of capital, but they only make sense if they're purchasing shares when they're undervalued," he says. "We like to see firms that use cash to build the business organically. If companies buy back shares at the top of the market, that's actually value destructive."

More from Grow: