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Net Net: Promoting innovation and managing change

This is how companies will keep pumping stocks

How important are stock buybacks?

For five years the game's been the same: Where retail investors have avoided stocks, corporate boards have stepped in to fill the void, pumping more than $1 trillion into the market to keep prices afloat.

At least on its face, the result has been a resounding success. The index has rallied 180 percent off its March 2009 low to a succession of new highs, underpinned at every juncture by companies buying back their own shares.

So a data release this week showing that the pace of buybacks slowed in the first quarter generated an understandable level of worry that if the Wall Street profit engine is denied its primary source of fuel, the fast road to the top could start getting a little bumpy.

Traders on the floor of the New York Stock Exchange.
Getty Images

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Not to worry, though.

With so much riding on the outcome, and so much pressure coming from activist investors, it's unlikely the buyback trade will end anytime soon.

That's despite a report from market data agency TrimTabs, which said announced buybacks in the first quarter of $134.4 billion amount to the lowest level in five quarters.

"We're not seeing that at all," Binky Chadha, chief strategist at Deutsche Bank, said in an interview. "The trend is very solid and likely to go up and not down."

For evidence, Chadha has a raft of data plus a very big news development to boost his case—last week's bank stress test results, which saw almost all the big Wall Street financial institutions pass fairly easily. More important than passing, though, was that the banks got permission to start returning cash to shareholders, and in a big way.

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A solid dozen of the companies examined under the Federal Reserve's tests said they would begin buybacks. Wells Fargo led the parade, with just short of $17 billion, while JPMorgan Chase will do $6.5 billion and Bank of America has $6.5 billion on tap.

And that's not all.

Though activist investor Carl Icahn recently retreated from his very public push to get Apple to increase its buybacks, the company is expected to make an aggressive move to return cash to shareholders after 2013's bold $14 billion move. A slew of other companies also face pressure to keep up the trend.

In a separate report this week, Moody's rating service said it expects nonfinancial companies to build on buybacks, which the firm said increased 11 percent in 2013.

Those companies spent $201 billion on buybacks net of stock issuance—a key metric that shows not just total buying but by how much companies actually reduced share count. Decreasing shares and increasing share price has been itself a key to corporate America's continuing pattern of record earnings per share.

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"We expect similar share buyback activity in 2014 despite aggregate balance sheet strength, solid cash flow generation and low interest rates," Moody's said. "The skewing of shareholder returns toward dividends, recently announced dividend increases and higher stock price valuations may reduce the economic motivation to buy back shares, although shareholder activism could spur more aggressive activity."

Larry Fink pushes back

Buybacks have been helped as well by Fed policy.

The Fed has pushed its balance sheet to about $4.2 trillion as it has created money to use for purchasing government debt. In turn, the central bank has kept interest rates at record lows—its own policy rate is just above zero—allowing companies to rack up cheap debt and accrue nearly $2 trillion in cash, another record achieved in the fourth quarter of 2013.

The top 50 companies hold about half that total cash pile, with Apple, Microsoft, Google, Verizon and Pfizer alone banking $404 billion, according to Moody's.

"Equities are cyclical and earnings are cyclical, so payout ratios are cyclical. The question is where we are in the cycle. We're sort of in the middle of the cycle in general," Deutsche Bank's Chadha said. "Our take is the cycle has much further to run. Cycles always end with the Fed, and the Fed hasn't started yet" to tighten policy.

True, the Fed has begun to reduce the amount of liquidity it provides to the market each month, taking its purchases down to a still-hefty $55 billion as it looks to unwind the program completely by the end of the year.

But interest rate hikes likely wouldn't come until mid-2015—plenty of time for corporations to keep using cheap money to buy back their stocks.

If there's a stumbling block ahead, the main problem will come from retail investors and portfolio managers, who have been singing a different tune than Icahn and his hedge fund brethren.

They want to see companies start to invest in capital expenditures and hiring—in other words, growth that would promote a more even economic recovery and focus on something other than boosting equity prices.

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"On a short-term basis, buybacks are a win-win situation," said Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. "Longer term, that's a different story." Silverblatt also believes the trend is significantly higher for buybacks and probably only a bit higher for capital expenditures with little of that money spent on things that would boost employment.

Wall Street economists are enthusiastic that capex will pick up this year, though Moody's said on an annualized basis it expects "incremental" gains.

Another issue: As the market keeps ripping higher, stocks could start getting too pricey and cause companies to wait for the long-anticipated correction before stepping in.

"Maybe a lot of insiders are concluding that stocks aren't a screaming buy, or managers think their stocks are not undervalued," said Brian Gendreau, chief market strategist at Cetera Investment Management. "Because stock prices are appreciating and basically have gone up faster than earnings, a pullback of some sort is highly likely."