Share buybacks
Comment of the Day

August 22 2013

Commentary by Eoin Treacy

Share buybacks

Eoin Treacy's view Share buybacks – In an ultra-low interest rate environment, corporations have been taking advantage of some of the lowest costs for capital in history to increase their debt load. One of the primary uses for this additional capital has been in refinancing older more expensive debt and therefore reducing the weighted average cost of capital for the whole company.

The stock market has been another important destination for this additional capital. Corporations have been in cost cutting mode since 2008 and the efficiency gains they achieved helped propel Wall Street higher from its lows of early 2009. Corporations have built up substantial cash reserves, often overseas, which would be taxed if they were repatriated. With top line growth increasingly difficult to achieve, stock market performance has been flattered by taking on additional debt and using the proceeds to buy back shares and to maintain or increase dividends. Apple represents a useful example of just this practice.

The PowerShares Buyback Achievers ETF (PKW) tracks the NASDAQ buyback Achievers total return Index. While the constituents of the Index are proprietary, the fund has 201 constituents which are not limited to Nasal-listed companies. To be admitted to the Index a company needs to have bought back 5% of its outstanding shares on a trailing 12-month basis. The pace of the ETF's advance has increased this year. It found support in the region of the 200-day MA from late June and surged to new highs. A process of mean reversion now appears to be underway.

The effect of share buybacks is to reduce supply which helps to support prices. Last January I created a chart of the number of shares outstanding on the NYSE in an attempt to monitor the net effect on supply of share buybacks, rights issues, private equity buying and selling, takeovers and IPOs. The Index levelled off from 2006 and trended lower, losing approximately 12% of the shares outstanding by February. However, the Index has spiked higher over the last few months suggesting that despite share buybacks, the supply of stock is increasing.

This article from highlights the fact that the US IPO market has raised $25.6 billion so far this year. With additional IPOs in the pipeline, for example Blackrock is talking about listing Hilton Hotels, the prospect of additional supply reaching the market is increasing

The Fed is currently weighing how to remove the risk of blowing another asset bubble, potentially in high yield bonds or mortgage REITS, while at the same time providing enough support to foster growth and lower unemployment. Talking about tapering has succeeded in raising borrowing costs and squeezing some of the more leveraged participants out of the bond markets. The municipals sector has been particularly hard hit for example. At some point, action will need to replace words or speculators will return to these instruments and the Fed will be presented with an identical problem.

Whenever tapering begins, it spells the beginning of the end for ultra-low rates. This will be felt most heavily by fixed income instruments but companies' most prolific source of credit will also be affected. This is likely to have an impact on buyback programs and dividend increases funded from borrowing. Considering just how well the PKW has performed, it is probably now appropriate to ask how sustainable the bullish scenario is, particularly following the accelerated pace of the advance and overextension relative to the 200-day MA.

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