The ongoing low interest rate environment continues to encourage companies to repurchase their own shares. In fact, in 2014’s first three months (1Q14) companies included in the S&P 500 bought $159 billion of stock. This was the second highest total on record, trailing only 3Q07’s $172 billion. Some companies are thought to base their repurchase decision on their earnings yield. (The earnings yield is the reciprocal of the price-to-earnings ratio or earnings-to-price.) If the earnings yield is more than the cost to borrow, they are willing to repurchase shares. For example, if a company’s P/E is 20, then its earnings yield is 5%. If the company can issue a long-term note at an interest rate below 5%, it may be willing to do so. It can then use at least a portion of the proceeds to fund share repurchases.
A June 29th Wall Street Journal article titled, “Stocks’ Biggest Gains Are an Inside Job” started with a quiz: “Quick, what is the stock market’s biggest driver today? Corporate earnings? Interest rates? The Federal Reserve?” The answer to that question is none of the above, but rather: “Some say the correct answer is something people rarely discuss: companies buying back their own stock.”
Share buybacks are something we pay close attention to and have written about in the past. (See here and here) We watch share repurchase activity carefully, because the decision to buy back stock is one way in which management allocates capital. Based on data compiled from Bloomberg, since 1Q09 (when the current bull market started) through 1Q14, companies in the Russell 1000 index (the largest 1,000 US companies by market capitalization), have repurchased more than $2.3 trillion of their shares. According to Federal Reserve Board Flow of Funds Accounts data, this activity level sharply outpaced purchases by households (-$940 billion), equity mutual funds ($290 billion), equity ETFs ($534 billion, institutional investors (-$336 million) and foreign investors ($256 billion).
At some point, interest rates are likely to increase. We do not expect this to happen any sooner than 2Q15, and it could take longer. When the Fed raises interest rates, the tailwind that share repurchase activity has had on the market will likely dissipate. It is also important to remember that it has been more than 1,000 days since the S&P 500 has fallen 10% from its recent high level mark. Corrections should be viewed as a normal part of any market cycle. All markets have regular pullbacks and consolidations. Corrections are impossible to forecast. Trying to do so is likely to result in additional trading costs and taxes.
Given our long-term investment approach, we view corrections as opportunities. They can be used to rebalance our asset allocation by adding to those asset classes that have declined or to acquire shares of quality businesses that have fallen disproportionally at a discounted price. We recognize that a falling market is more unnerving than a rising one. But sell-offs do happen. They are normal. We do not pretend to know when the next correction or even bear market will take place, but we remain vigilant and disciplined in our approach.