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Time to Be Bullish on Share Buybacks, Says Belski

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American companies are flush with cash, and they’re using it to splurge on themselves.

Companies in the Standard & Poor’s 500 index bought back $400 billion of their own stock in the 12 months through March, using more than 70% of their collective free cash flow to soak up more than 3% of their outstanding shares, according to FactSet.

In a slow-growth world economy, crisis-tempered and recession-scarred company executives are using an outsized helping of their healthy profits along with some ultra-cheap debt to repurchase equity from the public.

Brian Belski, chief investment strategist at BMO Capital Markets, expects this trend to continue a while, and he says in the attached video that this “really is a good thing” at this phase of an economic recovery and bull market.

Buybacks return cash to investors who elect to sell in a tax-efficient way, proportionally giving each shareholder a larger share of a company and its future earnings, in turn giving a lift to reported per-share earnings.

Companies have, in general, been hesitant to commit to heavier capital spending or aggressive hiring, and they are acquiring other companies at an unexpectedly slow pace relative to how strong the stock market has been and the maturity of the profit cycle. They are largely focused on sharing capital with investors through buybacks and, to some degree, with dividend increases.

“Let’s face it,” Belski says, “CEOs and CFOs in America are getting paid to stay conservative.”

With interest rates still low and unlikely to rise to historically more normal levels in a great hurry, companies are likely to stay with the buyback theme. Belski notes that any progress on corporate tax reform encouraging the repatriation of overseas cash could even accelerate the buyback trend for a time.

Related: Is Wall Street Now Immune to D.C. Dysfunction?

The heavy flow of buybacks in recent years has helped provide a steady source of demand for stocks that has exceeded new issuance of equity, supporting share prices to a degree. Belski notes that a basic principle of investing is to “buy scarcity and sell capacity,” and buybacks make equities more scarce.

Investors have typically been rewarded for owning shares in companies that stress stock buybacks, according to Belski’s research. Since 1990, the broad U.S. stock market has returned an average of 9.5% a year.

The 100 companies executing the largest buybacks relative to their market value each year over that period returned 14.2% annually. Filtering this latter group for stocks offering “growth at a reasonable price” and the average return rises to 17.9%.

This exercise essentially sifts the market for companies with “conservative management, that make their earnings,” yet with a price-to-earnings multiple below the market average and better profit growth than the index as a whole.

Belski last week screened for S&P 500 stocks meeting all these parameters and turned up names such as Aetna Inc. (AET), AutoZone Inc. (AZO), Dover Corp. (DOV), General Motors Co. (GM), Macy's Inc. (M), Time Warner Cable Inc. (TWC) and Wyndham Worldwide Corp. (WYN).

Of course, buybacks aren’t a free lunch. With the average stock having more than doubled since the 2009 market low and equity valuations no longer cheap, it’s harder to argue that using shareholder cash to buy shares at today’s levels represents a tasty bargain.

Many rightly argue that buybacks are a shortsighted, unimaginative use of cash relative to investing for future growth. And buyback booms tend to peak along with stock indexes, as happened in 2007, when record buyback volumes preceded the financial crisis meltdown.

Related: Buyback Binge Another Sign of Market Peak, Says Elliott Wave's Hochberg

Belski acknowledges that ultimately this trend can go too far for investors’ own good. Yet he doesn’t see many of the bright warning flares. Merger-and-acquisition activity is light, and we lack the credit stresses that undermined the market and economy in 2007 and 2008.

Still, before long he suggests companies will need to begin “investing in themselves,” in the form of expanding production capacity and spending on long-term growth projects, given that profit margins are near historical peaks.

“This will be the next part of the bull market and recovery,” he says. Until it gets moving in a broad way, though, he’s happy to see companies throw money at themselves.

More from Michael Santoli, senior columnist at Yahoo! Finance, can be found on Unexpected Returns.

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