Share buybacks have been good to investors over the course of the bull market, but there's a downside: If buyback activity dries up, where is earnings growth going to come from?
So far during the second-quarter reporting season, companies in the S&P 500 have been delivering impressive results. Earnings are growing at a pace of 7.5 per cent over last year, according to FactSet Research Systems.
That's the strongest growth in nearly three years.
What's more, about 74 per cent of companies have beaten analysts' estimates, suggesting that stocks could be attractively valued even after more than five years of outstanding gains.
But corporate earnings come with a wrinkle: To a large extent, they are being driven by companies buying back their own shares, masking less impressive underlying fundamental growth in net income and sales.
Buyback activity lowers the number of outstanding shares and therefore drives up earnings on a per-share basis – and it smacks of financial engineering to anyone who is growing skeptical about the bull market's advanced age.
According to Standard & Poor's, buybacks in the first quarter alone totalled an astounding $159-billion (U.S.), up more than 59 per cent over the first quarter of last year and close to the record $172-billion set in 2007, before the financial crisis set in.
Apple Inc. purchased $18-billion of its own shares during the first quarter, boosting earnings-per-share by 7.1 per cent.
International Business Machines purchased more than $8-billion of its own shares, bringing the total to more than $70-billion over the past five years.
Here's where the math gets interesting. While IBM's annual net income rose a decent 23 per cent between 2009 and 2013, earnings-per-share have grown by 49 per cent, or more than double the pace.
Share buybacks explain the difference. Indeed, an oft-cited study by JPMorgan found that buybacks accounted for an amazing 60 per cent of the gain in earning-per-share between the third quarter of 2011 and the first quarter of 2013. Organic growth accounted for just 40 per cent.
Market watchers are noticing.
"The bull market in stocks has been driven mostly by corporate share buybacks," said Ed Yardeni, chief investment strategist at Yardeni Research, in a note.
For him, it's a reason to stay bullish: Since stocks are often valued by comparing prices with earnings per share, buybacks can also hold down valuations and make the market look relatively attractive.
But David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, noted that if you looked at profit derived strictly from economic activity, the price-to-earnings ratio for the S&P 500 would be above 20 right now.
"It is this valuation extreme that likely has many equity investors a tad unnerved for the time being," he said in a note, adding that a 20-per-cent correction would be needed to bring the "organic P/E multiple" down to a more palatable 16-times earnings.
That's not his forecast. However, it is easy to see surging buyback activity as a contrarian indicator. Activity peaked before the financial crisis, bottomed out during the bear market low in 2009, and surged over the past five years as the S&P 500 nearly tripled from its lows.
In other words, companies don't necessarily buy their own shares when prices are attractive – but rather when the economy is expanding and corporate coffers are flush with cash.
As Mr. Yardeni observed recently: "When the next recession hits, corporate cash flow will decline and investors are likely to be less willing to buy corporate bonds. As a result, buybacks will dry up as they did during 2008, exacerbating the eventual bear market in stocks."
Buybacks have made earnings look very good in recent years. Without their help, earnings will look very different.