Making money with share buybacks

U.S. equity markets may be at record highs, but there is one factor that should give investors even more comfort than in previous periods.

That factor is share buybacks, which have altered the supply-demand dynamics for stocks, said Ronald Dottin, a quantitative analyst at RBC Capital Markets.

He noted the value of completed buybacks for S&P 500 companies in the past 12 months stands at US$412-billion. That is equivalent to removing all of the shares of Apple Inc., the second-largest company in the index.

“With equities making new all time highs now on a daily basis, the justification for share repurchases starts to wane – at least in the eyes of investors,” Mr. Dottin said in a note to clients. “However, it is important to remember that new highs did not stop companies from buying back their own shares.”

He pointed out the last time the U.S. market was making new highs on a consistent basis was back in 2006/2007, when the peak buyback amount was 42% higher than what has been spent in the past 12 months.

“New highs in 2006/2007 did not stop companies from buying back their own shares – the credit crisis did,” Mr. Dottin said.

He noted the buyback theme has essentially been in place since 2011, with the US123-billion announced in the second quarter about the same amount as during the previous three months.

The analyst also said that two-thirds of the new buyback announcements since the first quarter of 2013 have come from sectors that are relative underperformers: technology, materials and energy.

“Surely, companies in these sectors still have a compelling case for actively buying back stocks,” Mr. Dottin said. “Therefore, we believe any potential slow down is likely to be more gradual.”

He recommends two portfolios for capturing the potential upside from buyback activity.

The first, a near-term strategy, targets companies with high short interest that are actively buying back stock.

Mr. Dottin found that most of the excess within the top 20% of highly shorted names comes from companies that are actively buying back their shares. This group is outperforming the market by more than 500 basis points this year.

Gamestop Corp., Carmax Inc., Kohl’s Corp., Petsmart Inc., Staples Inc., Patterson Cos. Inc., Hormel Foods Corp., McCormick & Co. Inc., Sysco Corp., Harris Corp., Intuit Inc., Netapp Inc. and Nvidia Corp. made the list.

The analyst’s second, more conservative and longer-term approach targets shareholder yield. It involves matching stocks with sizeable buyback programs with companies that also pay significant dividends.

“The returns of this portfolio may be lower than buybacks on a standalone basis, but it should offer some protection if companies were to abruptly turn-off the spigot of share repurchases,” Mr. Dottin said.

This criteria produced a list that includes Home Depot Inc., Nordstrom Inc., Kohl’s, Lowe’s Cos. Inc., Macy’s Inc., Petsmart, Staples Inc., Target Corp., General Mills Inc., Proctor & Gamble Co., J.M. Smucker Co., Sysco, Wal-Mart Stores Inc., Accenture PLC, Cisco Systems Inc., Hewlett-Packard Co., Harris Corp., KLA-Tencor Corp., Nvidia and Seagate Technology PLC.

So while companies have enough dry powder too keep this trend running at a solid pace, the analyst noted the gap between dividends and buybacks will likely narrow — particularly if financials continue to produce substantial earnings surprises.

He pointed out that the sector was responsible for 20% of the broader markets’ dividend prior to the credit crisis, versus about 14% currently. As financials gain in productivity, they are expected to recapture some of their lost dividend weighting.

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