Buybacks boost earnings, as valuations rise, profits lag
As stocks rallied to record levels, corporate America has been announcing share buybacks at a near record pace, supporting richer stock prices for companies with low single-digit percentage earnings growth.
"There's no doubt that stock buybacks have helped boost EPS [earnings per share] growth, although you could make the case that as long as companies are buying back their stocks, people should do it as well," said Daniel Greenhaus, global market strategist at BTIG.
Buybacks are in focus at a time when expectations for slow earnings growth, along with rising valuations have become a topic of debate. So far, earnings for the third quarter have grown around 4 percent, and the price to earnings ratio of the S&P 500 is now close to 16.5, above its long-term average of 15.8. Some analysts see the market as now fairly valued versus earlier in the year, when the PE was much lower.
The buybacks have also helped the stock prices of some companies. "If you look at the S&P buy back achievers index, it's up 40 percent this year," said Jack Abilin, CIO of BMO Private Bank. The Power Buyback Achievers Portfolio ETF (PWK) is up about 38 percent year-to-date.
"Buybacks also tend to cushion the price drop in a down market because a company tends to come in and nibble at its stock," he said.
Companies certainly have been helping drive the market higher. According to Birinyi Associates, companies announced $59.93 billion in buybacks in October, the busiest October since 2007, which saw over $65 billion in buybacks announced.
(Read more: Icahn to Apple: I want a $150 billion buyback)
Howard Silverblatt, S&P/Capital IQ senior index analyst, said he has recorded buyback data for about half the S&P 500 companies for the third quarter, and buybacks are running well ahead of the second quarter, up 23 percent, if Apple is not counted. Apple bought the largest number of shares ever in a single quarter, when it spent $16 billion on stock buybacks in the second quarter. It bought $4.9 billion in the third quarter. If Apple is included, buybacks are up 0.9 percent from last quarter, based on the data he has examined so far, Silverblatt said.
The overall impact on earnings is not clear, and Silverblatt said it appears it could be minor in the third quarter, especially since the share count has not changed that much, indicating that companies could be using share purchases to cover options. He said Halliburton was a standout in the third quarter, reducing its shares by 3.7 percent. A smaller float means less stock to divide the company's net income by, resulting in higher earnings per share.
S&P/Capital IQ chief equity strategist Sam Stovall said buybacks are also a technique used by companies that want to boost earnings and see nothing else to invest in. "I'd rather see a pickup in M&A (merger and acquisition) activity…and a tailing off of share repurchases because then management is saying 'we see other ways to invest our money.'"
Besides buying back large amounts of stock, companies have been funding their purchases with debt, since interest rates are near record lows. With the Fed keeping interest rates low, companies are also rushing to issue debt, some of which is being used to fund buybacks. For October, there was $81 billion in investment grade debt issued, the largest amount ever for an October, and $25 billion in high-yield debt, according to Informa Global Markets.
Year-to-date, companies have issued $873.1 billion in debt, up from last year's $813.5 billion, according to Informa Global Markets. "The ability to use the cash on your balance sheet, if you can borrow at very cheap rates to invest in your company is compelling," said Bob Doll, chief U.S. equity strategist at Nuveen Asset Management. "I'm surprised there hasn't been more of it."
Doll said the contribution to earnings amounts to roughly 2 percent of the EPS gains in the S&P over a 12 month period. "It's a big contributor. Companies are being smart. Balance sheets are underleveraged," he said.
Apple is funding its $50 billion buyback program with debt, and there are many others, including Merck, which announced a $15 billion buyback this year, according to Birinyi Associates.
(Read more: Morgan Stanley to seek share buyback OK: Report)
Andrew Wilkinson, chief economic strategist at Miller Tabak, said the performance of companies that buy back shares has outpaced the indices also when looking longer term. He said since the start of 2000, the S&P buyback index is 20 percent higher than the S&P 500. It measures the performance of 100 companies with the highest buyback ratio for four consecutive preceding quarters. The Nasdaq has underperformed Nasdaq Composite buyback stocks even more. The basket has quadrupled, he said, while the Nasdaq is still below the value it was at the end of 1999.
Willkinson reviewed the performances of several companies that have large buyback programs. "I ran a really quick 'what-if' to show what impact it would have on EPS assuming [the number] of shares was kept constant from either [2008 or 2009] levels," he wrote in an email.
"Oracle would have lower EPS by 8.9 percent today while Direct TV would be 46.9 percent lower," had it not bought back its stock. Wynn's $3.14 per share earnings would 23 percent lower, and Motorola would be 17 percent lower, if it had not reduced shares outstanding from 323.6 million to 265.3 million.
"You'd like to see EPS grow indefinitely at 8 to 10 percent, but that's not the case," said Greenhaus. "What gets overlooked… in this is what's supposed to happen. Everyone is lamenting the rate of buybacks. What happens in numerous cycles is earnings growth slows down. It's a baton toss, you hand the baton off from an earnings driven rally to a multiple driven rally."
(Read more: Apple now hoards 10% of US corporate cash)
Greenhaus said the fact that the market's PE in now above the historical average, is not an issue itself since it is an average; however it is getting more fully valued. "The market is no longer a buy as it has been for some time. Now you are relatively speaking much more in line with historical norms," he said.
—By CNBC's Patti Domm. Follow here on Twitter