The market rally of the past twelve months may appear somewhat baffling in light of the fact that individual investors have been pulling money out of the market. The S&P 500 is up 22.5% in the last year, while September marks the 17th consecutive month during which investors took money out of equity mutual funds. The outflows from equity mutual funds are not simply due to investors moving from mutual funds to ETFs. A recent analysis by Bianco Research demonstrates that including ETF flows does not change the results.
So if individual investors are selling, who is buying? Ron Surz nicely summarizes the data in a recent article. The massive buying that is driving up market prices is share buybacks. Companies are using their own money to repurchase their shares. He cites data showing that net investor redemptions from equity mutual funds totaled $32 Billion in the first nine months of 2012, while share buybacks totaled $300 Billion. For some enlightening charts and figures, see this report from FactSet.
A company’s decision to repurchase its own shares on the open market reflects a decision about how best to use capital resources. A company that has substantial cash on hand has three choices. It can pay a special dividend to investors, invest in new growth opportunities, or repurchase shares. The decision is partly driven by management’s outlook as to the returns from growth, as well as the rates at which the company can borrow by issuing bonds. When a company can borrow cheaply (bonds yields are low, as they are today), share repurchases look more attractive.
While buybacks can be a perfectly rational way for companies to spend their money, a 2012 study from Credit Suisse (published in June) suggests that buybacks are quite often to the detriment of current shareholders. While buybacks will increase the earnings per share (EPS), that does not mean that investors necessarily benefit. The real question is whether the company can purchase its own shares below their ‘fair’ value. If the company can buy its own shares at a discount to intrinsic value, the buyback adds value. This report is well worth reading.
The data suggests that the current bull market in equities has been substantially driven by share buybacks. Furthermore, there is evidence that share buybacks may not add value for current investors. When both of these factors are taken together, the rise in stock market value in 2012 looks a lot less impressive.
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