foxex: Buybacks and Dividends are a Gift

Focus on the Price

Tuesday, December 25, 2018

1. Increased giving to shareholders

2. Share buybacks rocketed to all-time highs in 2018

3. Dividend payments maintain their bullish trend

Major Moves

Congress gave Corporate America an amazing Christmas gift last year when it passed the Tax Cuts and Jobs Act. This tax plan slashed corporate tax rates and made it possible for large multi-national firms that were stockpiling cash overseas to repatriate that money to the United States at a lower tax rate.

Companies like Apple (AAPL) – which had more than $250 billion parked overseas – Microsoft (MSFT) and Cisco (CSCO) began bringing money back to the U.S. at an astounding pace.

Once the money was back home, however, these companies had to decide what to do with it.

Advocates of the tax changes had hoped these companies would reinvest the money, expand their businesses and create more jobs. Pragmatists on Wall Street, on the other hand, knew that economic demand didn't warrant that much business expansion and that management teams would most likely look to boost share prices by returning the cash to shareholders.

This is exactly what happened.

As soon as the money started flowing in, corporate managers began ramping up their share buyback programs and increasing their dividend payments.

Many analysts suggest that without these corporate actions, the S&P 500 would be at a much lower level than it currently is. I completely agree.

Share Buybacks

Share buybacks are a great way for managers to provide a temporary lift to share values.

When analysts work to determine how much they believe a stock should be worth, one key number they look at is earnings per share (EPS). The larger the earnings, the more valuable the share.

EPS can increase in one of two ways: either earnings can increase or the number of shares can decrease.

When a company buys back its own shares, it is effectively decreasing the number of shares that can lay claim to the earnings the company is generating.

For example, if a company earns $100 and there are 100 shares outstanding, the EPS is $1 ($100 / 100 shares = $1 per share). Similarly, if a company earns $100 and buys back 50 shares so there are now only 50 shares outstanding, the EPS is $2 ($100 / 50 shares = $2 per share). The company didn't increase its earnings at all, but by buying back its shares, it doubled its EPS.

After the Trump Tax Plan passed, Corporate America kicked its share buyback activities into high gear. The high-water mark previously established in Q3 2007 was blown away as companies spent more and more, finally crossing the $200 billion threshold in Q3 of this year – spending a total of $203.8 billion on share buybacks.

Interestingly, companies don't typically engage in their share buyback programs in the immediate run up to their earnings announcements. They don't want to be seen as trading (buying their own stock) on insider information that is not yet available to the public.

The month, or so, before a company's earnings announcement is called its "blackout period." Many Financial, Transportation and Telecom stocks have already entered their blackout period for the Q4 2018 earnings season, which will start in early-January 2019. This means they have paused buying back their own stock and are no longer able to provide support to share prices.

Source: Yardeni Research, Inc.

Dividends

Paying dividends is the most traditional method companies use to return cash to shareholders.

Income investors love dividends because they provide income on a regular (typically quarterly) basis. Other investors love dividends because they provide a clear way to analyze the fiscal strength of the company because companies must have solid cash flow to be able to make their dividend payments.

When a company starts paying dividends, it is committing to pay those dividends for the long term. Management teams know that if they cut, or cancel, their dividend payments, traders will view that as a sign of fiscal weakness and will slash the price they are willing to pay for the company's stock. Because of this, management teams are typically quite cautious with their dividend decisions.

On the other hand, if a company can steadily increase its dividend payments, it is like to be rewarded by Wall Street with an increase in its share price.

This is what we have been seeing since late-2009. Companies have been increasing their dividend payments, and those increases have been accelerating during the past year.

When Corporate America is confident enough to consistently increase dividend payments, it tends to pass that confidence on to the traders who are buying the stock.

Source: Yardeni Research, Inc.

Bottom line: Buybacks and dividends may not be enough

Unfortunately, while share buybacks and increasing dividend payments have certainly provided more lift to the stock market than would have been there without these programs, they may not be enough to keep the bull market going.

Faltering confidence in the future strength of the U.S. economy, the Federal Reserve's commitment to continue raising interest rates (even at a more moderated pace) and the seemingly unrelenting uncertainty in trade policy and politics these days may prove too much for corporate management teams to overcome by returning cash to shareholders.