This has been quite the year for share repurchases.
The Wall Street Journal recently reported that the companies in the S&P 500 -- flush with cash repatriated from overseas -- are on pace to buy back $800 billion worth of stock this year. This amount would break the previous record ($589 billion, set in 2007) by more than $200 billion.
That's an enormous amount of capital to be allocated. But after a nearly decadelong bull market, is now really the right time for companies to be buying back shares?
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As it turns out, the answer is probably yes. Catalyst Funds' COO Michael Schoonover -- who also runs Catalyst's Buyback Strategy Fund -- has found that over the past 28 years, companies that repurchase shares generally outperform the broader market. That span of time covers bull markets, bear markets, and sideways markets.
I recently spoke with Schoonover about America's current buyback environment, and he mentioned three companies that investors should consider. But first, let's look more broadly at what companies should and shouldn't be doing with regard to share repurchases.
How NOT to do buybacks
The first thing we should note is that not all buybacks are created equal.
General Electric (GE -1.04%) has been perhaps the textbook example of bad buyback behavior. The company has spent billions of dollars repurchasing shares in recent years, only to see its stock price fall precipitously. It might be fair to call that "lighting shareholders' capital on fire."
A closer look offers some insight as to what went wrong. GE was continually missing its revenue targets, but at the same time was conveniently still hitting its earnings targets. That should have been a red flag for investors.
As it turned out, GE was doing some financial engineering within its divisions. Nothing illegal, but it was liberally allocating profits between divisions and perennially buying back shares. This reduced the denominator in its earnings per share calculations, which were reported to and compared to Wall Street's expectations.
Schoonover shared some insight as well about GE, and how investors should think about how large corporations repurchase shares:
With so much buyback activity going on, it comes down to how do you find the best signals to invest in? I think GE is a great example, as well as IBM. They have used buybacks more as a financial engineering tool to maintain earnings per share in a declining earnings environment, versus an opportunity to buy their shares at a great price.
The size of the buyback program really says a lot about the company's commitment and their confidence in the long-term investment opportunity of their stock. If you think about it, it's the company's board of directors and executives all getting together. They're evaluating all the possible projects on the table, and they're saying: "Look, we want to be authorized to repurchase our own shares. We think that's better than pursuing a different option right now." Versus what you see with a GE or IBM, where they're saying, "If we buy back this amount of shares, we essentially can't maintain our EPS in an environment that's challenging for the company."
A company's board of directors (should) have a long list of ideas on how to allocate capital. As investors, we should make sure they're making the most strategic long-term decisions.
3 factors to watch for instead
Hindsight is always 20/20. It's easy for us now to criticize GE's past buyback decisions.
But looking forward, Schoonover also shares three quantitative things that Catalyst screens for, which could indicate that a company is correctly making those strategic long-term decisions.
The first thing Catalyst looks for, he says, is that the share repurchase is recent and fresh in investors' minds:
We look at, one, how long has it been since the announcement time? So the closer to the announcement, the better. What we find is that vast majority of the alpha happens during 30 days, although you still have alpha going all the way out to 90 days.
The second is the proportion of shares authorized for repurchase, Schoonover says, as compared to the total number of shares outstanding:
A second factor that we look at is the size of the announcement. And that's size in terms of percentage of shares outstanding. So, a small company announcing a $100 million buyback could be much more meaningful than a very large company only announcing a $1 billion buyback, for example. And that's because a buyback strategy is really a strategy with a very intuitive catalyst.
It's something where these companies, if they believe their stock's undervalued, they're allowed to buy up to 25% of the average daily volume of their shares. They can really go out there and make a difference. So for us, the larger the buyback announcements, the better. And that's what our research shows.
Last, he says, is to look for companies with a history of outperformance (noting that "past price appreciation" is also one of David Gardner's six signs of a Rule Breaker):
And on the third factor that we look at is simply how well the stock has already performed since the buyback announcement. So we look at every single U.S. stock that's announced a buyback and rank it on those three measures. And then we hold the top 30 after performing some qualitative review on those.
3 companies doing buybacks right
With those factors in mind, I asked Schoonover to name a few companies doing a good job at buying back shares:
A great example is QEP Resources (QEP). It's a U.S.-based natural gas company. A lot of soft-sided research came out in December and January, really punishing the stock. And finally at the end of February, the company came out and authorized a 60% buyback announcement. Meaning that they would go there and repurchase up to 60% of all of their outstanding shares. The three-month period following that buyback announcement, the shares rallied 40% versus the S&P flat.
And then [another example] in a similar situation are Sonic Corp. (SONC), the restaurant company, had a pretty huge short interest in early June at over 10%, but the company came out and announced a 50% buyback announcement. Shares rallied 25% in one week, and the short interest dropped all the way down to 3%. So they really used the buyback announcement as almost a short-squeeze tool.
And then the third example is Crocs (CROX -1.97%), the shoe company. And they also came out at the end of February after they had a good earnings report that topped estimates, but they gave some relatively weak outlook for 2018. Then the shares got punished, then the company announced a 28.7% buyback announcement. And then over the three-month period following, the shares rallied almost 46% versus the S&P flat again.
The Foolish bottom line
There's a lot of money on Corporate America's balance sheet right now, and much of it is being used for share repurchases. Investors can maximize their returns by finding companies that are buying back shares for the right reasons.
