Big Stock Buybacks May Lead to Hefty Gains

TheStreet.com

NEW YORK (TheStreet) - Corporate America is returning cash to shareholders instead of hoarding it, helping to generate decent returns in a slow-growing economy.

Chief executives spent more than $370 billion on buybacks in 2011, the most since pre-recession levels. Momentum continues in 2012 with seven of the new repurchase plans weighing in at more than $1.5 billion. AT&T announced the largest plan at $9 billion, followed by Comcast at $6.5 billion and DirecTV at $6 billion.

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The moves suggest that executives are more confident about their companies' prospects, given their improved balance sheets, the stabilizing economy and low interest rates.

Cash per share for the S&P 500 was almost $300 in 2011, a high for the index. On top of that, free cash flow for the group has also increased and is yielding 8%, the highest since 2008 when the S&P was yielding 10% as stock prices were tumbling.

Given these levels of cash, it's easy to see why corporations are buying back shares. Chris Leavy, chief investment officer of fundamental equities in the Americas at BlackRock, says "companies are using free cash flow to fund the share repurchase programs, not cash on the balance sheet." That means companies haven't depleted their cash balances and can still use them to buy capital equipment or make acquisitions.

Buybacks are typically viewed positively by investors because they help drive stock prices up, at least in the near-term. They also reduce the company's share count which in-turn drives earnings growth. This is where Leavy thinks investors can benefit. On average, he estimates that share repurchase programs will reduce share count in the S&P 500 by 3%, and consequently increase EPS by 3%.

Leavy explains "even if valuations don't improve, you can still make 9% to 10% return on equity investments simply based on revenue growth of about 5%, flat margins, buyback related EPS growth of 3% and a dividend yield of 2%."

Many investors are still nervous about the stock market given the nearly 8% increase in the S&P 500 so far this year and the outlook for continued volatility by many economists in 2012. In contrast to Treasury bonds that yield about 2% and savings accounts that pay practically nothing, a 9% to 10% return on companies that are buying back their stock sounds pretty attractive.

Risk-averse investors have been pulling money out of equity funds during the past three years. If this trend continues, some investors fear that prices might not rise because there won't be demand for the shares. However, the demand created by new buyback programs is countering the trend, causing net demand for equities to be greater now than it was in the 1990s through the early 2000s, when equity fund inflows were stronger than buybacks. Multiple expansion should occur as a result.

Valuations have come down significantly since peaking in 2007. The S&P 500 is trading at 13 times earnings currently, which is below the 17 times it traded at in 2007. Between October 2007 and March 2009 (representing the market's peak and trough) the S&P 500 declined by 57%. At current valuations, assuming moderate growth for many companies and that dividends and buybacks remain intact, there are attractive opportunities in the equities market.

--Written by Lindsey Bell in New York.

>To follow the writer on Twitter, go to Lindsey Bell.

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