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Searching for Stocks With Payback Potential

by Mike Burnick on January 16, 2014

in Commodities, Stocks, Technical Analysis

Mike Burnick

The fourth-quarter earnings reporting season is upon us, with six of 30 Dow and 28 S&P 500 companies reporting this week. There is a lot riding on the results, but perhaps more so with stocks already off to a bad start in 2014.

S&P 500 profits grew about 6 percent year over year in the fourth quarter, according to forecasts, which puts full-year earnings growth at just 4.8 percent. Revenue growth for the blue-chip index was even more anemic, up just 2 percent, according to estimates.

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It’s hard to square a 32.4 percent total return in the S&P 500 Index last year with sales growth of just 2 percent and earnings growth of less than 5 percent.

Another way to look at these results is to recognize that 15 percent of the stock market’s gain in 2013 can be accounted for by fundamental earnings growth, while 85 percent of the gain came from a big expansion in the market’s price-to-earnings ratio.

So if stocks are to surge higher still in 2014, what factors will drive these gains?

I see at least two catalysts that could propel stock prices even higher from here, perhaps after this correction runs its course: more stockholder payback and the deflating bond market bubble.

In this article, let’s take a closer look at how you can get payback on your investments.

There are three ways for investors to get payback on their money, otherwise known by the fancy term of return on invested capital.

First, and what most investors focus on, is share-price appreciation. How much did my stock go up last year?

Second, for many investors, are dividend payments. There are a wide variety of popular dividend-stock strategies, including the Dogs of the Dow, which I covered last week.

Third is the fast-growing practice of share buybacks. This method of investor payback is perhaps not as obvious, but it has become one of the chief sources of shareholder wealth in recent years. A recent Wall Street Journal article summed up the trend well:

“U.S. companies are showering cash on shareholders, powering the stock market’s record-breaking rally.”

* During the third quarter of 2013, companies in the S&P 500 Index repurchased $128 billion worth of their own shares.

* On top of that, stocks in the blue-chip index paid another $79 billion in cash dividends to shareholders.

* Add up these two sources of shareholder payback and a total of $207 billion was returned to shareholders in just the three months ended September 2013. That’s very close to the record high of combined dividends and share buybacks generated just before the 2007 financial crisis.

While dividends pay in cash, buybacks return cash to investors in an indirect way — boosting a stock’s future per-share profits by reducing the number of outstanding shares. For the S&P 500 in aggregate it means that, even without strong sales growth, earnings per share can still expand at a faster clip, helping boost stock prices in the process.

Although share repurchases don’t grab investors’ attention the way earnings reports and dividend declarations do, buybacks have been a significant force in the stock market’s 173 percent rally over the past five years.

Since the S&P 500 hit bottom in March 2009, S&P 500 companies have spent nearly $3 trillion buying back stock and paying cash dividends in roughly a 60/40 ratio.

Remember, the past five years has been marked by extreme uncertainty: Uncertainty about monetary policy, uncertainty about the direction of Washington’s fiscal policies and uncertainty about the health of the economy.

In such an environment it makes sense why corporations that are flush with cash might decide to return the money to investors in the form of share buybacks and dividends instead of making long-term capital investments or spending on R&D.

In fact, stocks that frequently buy back shares have consistently rewarded investors in recent years (see graph below).

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The S&P 500 Buyback Index tracks the top 100 stocks in the index as measured by share buybacks. Last year, the list gained 48.8 percent compared to a 32.4 percent total return for the S&P 500 as a whole.

Some of America’s biggest and best-known blue chips top this list, including Home Depot (HD), Johnson & Johnson (JNJ) and Southwest Airlines (LUV). And over the past five years, the Buyback Index has outperformed the S&P 500 by 8 percentage points per year on average — up 27 percent annually versus 19 percent.

While interest rates remain close to historic lows and with U.S. corporations still flush with cash, dividends and especially share buybacks are likely to remain strong. This powerful underlying force can help support stock prices, pushing the market even higher in the year ahead.

Good investing,

Mike Burnick

P.S. Next week in Money and Markets, I’ll brief you about how another powerful force, shifting asset allocations, can propel stocks even higher. In the meantime, go to our Money and Markets Facebook page for a list of the top 20 stocks in the S&P 500 Buyback Index with the fastest sales growth.

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