At the end of the month, restrictions imposed on banks by the Fed will be lifted. This will allow banks to resume their regular dividend payouts and ability to buy back its own shares. However, in order to do so, they are required to pass the stress test – a test which provides results on the resilience and ability of banks to withstand economic shocks. But these are not the only companies that are engaging in share buybacks (also known as share repurchase). As the economy continues to recover, companies with excess cash have engaged in repurchasing their own shares. April alone saw over $200 billion in share buybacks; this is the second highest month on record behind the $209 billion repurchases made back in June 2018. I’m sure many of you are familiar with share buybacks in the news, but why might a company want to do this?

Let’s begin with what a buyback is. A company engages in a share buyback by going into the open market and “buying back” their own shares; effectively limiting the amount of shares outstanding or available. Thus, each shareholder will have an increased claim on the proportion of a company’s assets. This means that for every share outstanding, an owner of that share will have a larger claim to its dollars in sales, earnings and dividends, holding all else equal. This mechanic is the reason that companies engage in share buybacks – companies are looking to increase the value of each stock.

Banks were the only companies that had restrictions on share buybacks and dividend payouts, so why are other companies engaging in share buybacks in record numbers? Well, it’s easy to understand that many companies were faced with a great deal of uncertainty last year. As a result, companies that had cash available to invest decided to forego that spending until a clearer picture of the respective company’s environment became more certain. Additionally, there is a high correlation between share buybacks with the performance of the S&P 500, understandably so, as more companies are likely to generate positive levels of cash during a market uptrend. I point this out because recent economic data signals a continued recovery and move into some sense of normalcy. To further drive this point, David Kostin, Goldman Sachs Chief U.S. Equity Strategist, said in May that he estimates “a 35% increase in share buybacks this year, and a 5% pop in 2022”. Yet, having cash is not the only reason that companies have proposed buying back their own shares. Another reason is that the low interest rate environment has made borrowing for companies extremely cheap. This is important because a significant number of buybacks are financed using at least some amount of debt, or all debt. Thus, a company can borrow at low rates and use this cash to repurchase their own shares and all the company has to worry about is making a sufficient return for its shareholders.

At first glance, it appears that purchasing shares of a company that is buying back their own shares makes for a great investment as each share will eventually be more valuable. So, is there any downside to share buybacks? Some critics of share buybacks point to companies that use debt to fund their stock repurchases. They argue that a company is only attempting to drive their share price higher. One negative aspect of that notion is aimed at management compensation that is tied to the performance of their stock. By reducing the amount of shares available to trade, each share is entitled to a larger piece of the company’s pie – their earnings or their bottom line – which effectively makes the earnings per share rise. However, many companies that that took on more debt at cheaper rates did so to refinance their existing debt to the current low interest rate levels.

Other considerations that companies make when attempting to increase value for their shareholders is the company’s discretion and flexibility over the buybacks. Share buybacks are done at the company’s discretion and can be easily stopped compared to when a company decided to increase their dividend. Buybacks offer more flexibility because if a company decides to increase their dividend, and later find that they can’t continue to make that disbursement to their shareholders, the share price may be negatively impacted. However, unlike dividends, buybacks can be more readily decreased or stopped without experiencing some negative impact.

As an investor, companies repurchasing shares tends to be a good sign that there will be a sustained uptrend. But choosing which companies are managing and spending their cash wisely is of utmost importance. Briefly, signs of a healthy share repurchase program would be paired with a strong balance sheet, strong free cash flow generation, and attractive market valuation. As for companies using debt, be on the lookout out for ones over-leveraging themselves just to move up their share price.

– Jose Rendon