What’s the best way to “value” an individual stock? Price-to-earnings ratio? Price-to-book or sales? What about its dividend yield vs. market averages? Just as there are hundreds of investors, there are hundreds of ways to find value in the market. And while the jury is out on which factor or combination of factors is the 100% correct way to find cheap stocks with real growth behind them, investors continue to search for an edge.
And they may want to add buybacks to that list.
Historically, buybacks have been lauded by many market pundits as purely smoke and mirrors, with stock grants and employee stock options often totaling more than what is retired by companies. But according to Invesco, buybacks could be an additional tool in an investor’s playbook when looking for value.
The Other Way to Return Capital to Investors
There are really only two ways companies can return excess cash and profits back to their investors. They can pay dividends, which we all know and love. Or they can retire shares, by either buying them through private tender offerings or on the open market.
These buybacks reduce the overall share count. In doing so, they boost overall metrics such as earnings-per-share, as there are now fewer shares to spread the same amount of profit over. Likewise, in diminishing the supply of shares available to the public, they alter the supply-and-demand nature of the market. With fewer shares to go around, the theory is that prices will rise. So it’s easy to see why buybacks, in theory, are useful for investors when looking at total returns.
But analysts at Invesco have another idea when it comes to looking at buybacks, and that’s signaling “value” among shares.
An Insider’s View
They say that “the eyes are windows to the soul.” Well, buybacks could be the windows into value and cheap stocks. According to Invesco, fundamentals don’t always tell the complete picture when it comes to looking at a stock. All we have to go by is that, for example, Johnson & Johnson (JNJ) has a P/E of 24. We have no idea what conversation just went on in the boardroom about a new project or market they plan on entering.
And that’s just Invesco’s point. Management should have an insider view on the “competitive landscape, economic backdrop and industry trends affecting the firm.” This is a huge information advantage. You’re basically looking at legal insider trading. The decision to repurchase shares suggests that management sees buying stock as advantageous compared to other uses of that cash. By executing a buyback, investors can assume that management is reducing share count for a good reason.
And that signals value.
So how well does this strategy work? Pretty well, actually. Just take a look at the following chart from Invesco.
Source: Invesco’s Investment Blog
The thing to look at is the two bars – the plain old S&P 500 in green and the NASDAQ US Buyback Achievers Index in purple. The NASDAQ US Buyback Achievers Index measures stocks that have experienced a net reduction of 5% or more in shares outstanding over the trailing 12 months. That means the company actually bought back shares, and didn’t just buy them back and then hand them out as stock options or grants.
As you can see, the buyback index has managed to outperform the regular index in almost every year. Invesco points to the lower returns in 2014 and 2015 as periods when “value” was out of favor. The S&P 500 Pure Value Index was an underperformer during these years.
The fact that value and the buyback index were both underperforming underscores the relationship between value and buybacks.
Investment advisor Patrick O’Shaughnessy of the Investor’s Field Guide blog also highlights the buyback-value relationship. O’Shaughnessy looked at buybacks of quality stocks, which is a combination of value traits as well as good earnings, rather than accounting shenanigans. Again, those stocks that had value traits and committed to buybacks were better performers overall.
In the end, buyback activity does really signal potential values in the market.
What About Now?
So if stock buybacks do, in fact, signal values in the market, value investors shouldn’t be smiling right now. According to bank Société Générale, share repurchases by American companies are down 20% year-over-year in 2017. This follows another slight decline in buyback activity in 2016. And that sort of makes sense, given the lofty P/E and CAPE ratios of stocks. Equities are simply expensive after their torrid runs.
But there are values in the market. Investors could comb through lists of share counts to find the buyback leaders or they could take an easier route. The Invesco-sponsored PowerShares Buyback Achievers (PKW) does track the aforementioned NASDAQ US Buyback Achievers Index. By using the ETF as-is or combining its holdings, investors should be able to find what values the market may hold.
The Bottom Line
There are many ways to find “value” in the market. Investors may want to look beyond P/E ratios and take a look at net buyback activity. According to Invesco, firms that repurchase shares are actually signaling big-time values.