Constructive Destruction

Story Highlights:

• S&P 500 companies repurchased a record $589 billion of their own stock in 2007, surpassing as reported GAAP earnings totaling $587 billion.
• Stock buybacks remove shares from the market, increasing the value of remaining shares.
• Buyback activity is expected to continue in 2008, though not at 2007's incredible pace.

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(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)

Yesterday, Standard and Poor's released preliminary data regarding stock buyback activity for 2007. For those with short attention spans, we'll sum it up in one word—healthy. In fact, 2007 set a record for stock buyback activity. The third quarter alone saw $172 billion in buybacks—the largest quarterly expenditure of all time. Total up the year and you get a whopping $589 billion in corporate share repurchases.

Impressive, isn't it? But wait, there's more. Buyback activity in 2007 for S&P 500 companies actually surpassed as reported GAAP earnings of $587 billion for the year. Ten companies alone accounted for a combined $148 billion in buybacks, led by Exxon Mobil, Microsoft and IBM. Though the Energy, Financials, and Technology sectors were responsible for nearly half of stock buyback activity, sector participation was fairly broad. The report also notes that since the fourth quarter of 2004, S&P 500 companies laid down about $1.44 trillion on share repurchases. That's what we call constructive destruction.

Many companies, including the aforementioned behemoths, continue to hold large amounts of cash on their balance sheets. Now, one could argue the cash is best deployed towards investment activity, but recent GDP figures show continued growth in this area, which may simply be a reflection of just how much capital these big companies can access. Not only can they repurchase gobs of their own shares, they still have funds available for other investment opportunities.

Last week, MarketMinder addressed Financials' new share issuances in our April 2 cover story, "Don't Get High on Someone Else's Supply." The stock and rights offerings by beleaguered Financials received a warm welcome on Wall Street, but we cautioned that increasing share supply isn't normally a good thing for markets, assuming demand remains constant. However, we also noted share increases are, for now, mostly limited to Financials and relatively small, especially when compared to the current level of share destruction.

Investors seem giddy with stock offering announcements but remain indifferent to stock buybacks as a whole, which are conducive to rising stock prices. When a company removes shares from the market, it immediately increases earnings per share for those still holding shares—this is good. It's also good when a company beats the Street's expectations—which happened in 2007 more than most folks think, excluding Financials.

As noted several times in past commentaries, the current gap between earnings yields and government bond yields should continue to make cash-based M&A and stock buyback activity advantageous. While cash-based M&A remains a viable option for many companies striving to increase shareholder value, sometimes a share repurchase can provide the greatest value to shareholders.

Despite some Financials issuing new shares to raise capital, healthy companies will continue to take advantage of what is otherwise a friendly global economic environment for M&A and buybacks. This type of destruction should please investors (even if they'd rather focus on share issuances) and likely points to higher stock prices when all is said and done.

Source: Standard and Poor's