I came across a disturbing statistic today.
According to Morgan Stanley Research, companies are set to cut back on share buybacks — just as we enter an official bear market.
That’s terrible news!
Because when stocks trade lower, its a perfect time to buy MORE shares. Not to cut back on a buyback program.
Let’s take a look at how this financial transaction works – and how buybacks can help you as an investor.
I’ll also fill you in on some companies I’m watching that are still buying back shares. These companies are getting a better discount, and creating a lot more value for you as an investor.
How do Share Buybacks Work?
Many corporations use cash from profits to buy back shares of their stock.
The shares are then “retired” and disappear from the market. So the number of remaining shares is now lower.
Here’s why this is helpful to you as an investor.
Each share of stock that you own represents a small percent of the company. Let’s assume you own 10 shares out of a total 1,000 shares.
In this example, you own 1% of the total company.
If the company buys back 100 shares, you would still own 10 shares. But now, you would own 10 of 900 total shares which represents 1.1% of the entire company.
So without doing anything on your own, you would increase the size of your ownership by 10%.
And keep in mind, the company should continue to generate profits as normal. So you now get a bigger portion of ongoing profits.
Good and Bad Share Buybacks
As you can see, share buybacks can add value for investors over time. But there are times when these buybacks make sense — and times when they’re less effective.
Just like any other cash purchase, corporate managers should analyze how much they’re spending, and what value they’re getting for the purchase.
It’s also important to consider alternatives for that cash. (Could they use the cash to hire more people or expand into a new market?)
During bullish periods when business is good, opportunities are abundant and cash is pouring in, share buybacks are often NOT my favorite thing for companies to do with their cash.
Because typically that cash can be used to expand the business and grow profits.
And even if the company doesn’t need cash for growth opportunities, shares are typically expensive so it takes a lot of cash to buy back each share.
That’s not a great situation.
But when bear markets hit, it’s actually a much better time to buy back shares.
That’s because there typically aren’t as many opportunities for companies to expand. So there are fewer productive places for managers to spend the cash (on their own business).
Meanwhile, stock prices typically drop (like the bear market we’re seeing today). So share buybacks can actually repurchase more shares for the same amount of capital!
So as we enter a new bear market, this should be a perfect time for companies to buy back shares of stock.
Companies that ARE Buying Back Shares
I was surprised to see Morgan Stanley report that many companies are cutting back on share buybacks.
It sort of makes sense… Because profits are dropping and the future is less certain.
But so many stocks are down sharply. And many blue chip companies still holding huge cash balances from years of great profits.
Which means that cash can now be put to work buying MORE shares at discount prices.
One of the first major buyback stocks that comes to mind is Apple Inc. (AAPL).
The stock is down about 28% from its peak, but profits continue to roll in. Today, you can pick up shares of AAPL for about 20 times next year’s expected profits.
That’s a discount price compared to the premium valuation AAPL has had in the past. And it’s a discount price AAPL can take advantage of with their $90 billion share buyback program.
Broadcom Inc. (AVGO) also recently announced a $10 billion share buyback program which represents almost 5% of the company’s overall market cap.
With the stock down 23% from its peak, the company can get more bang for its buyback buck. And share buybacks may help to support the stock after its recent pullback.
I’ll keep my eye out for other buyback plays that make sense in today’s market. After all, a bear market is a great time to buy great stocks — and for great companies to buy their own stocks too!