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The net withdrawal of equity has been fairly large since the end of 2010. Our rough proxy for the historical impact of equity withdrawal suggests that buybacks have boosted EPS growth by two percentage points in the year to 2012 Q3. It would not be surprising to see a similar or higher contribution to EPS growth in 2013. But, do buybacks tell us anything about the economy or profit cycle apart from their mathematical impact on EPS?
Note that a surge in share buybacks generally occurs when economic activity is robust, but buybacks are not a leading indicator for the economy. Equity retirements typically ramp up only after real GDP growth has risen above a trend pace, and quickly fall off when growth drops below trend (about 2.5%). As such, buybacks are more of a reflection of the economic and financial landscape.
Relative prices and the capital structure matter as well.
As theory would suggest, corporations tend to leverage-up when corporate equities are undervalued relative to bonds. Our Capital Structure Preference Indicator highlights the strong incentive for firms to issue bonds and buy back stock at the moment. While buybacks can have a meaningful and immediate impact on EPS, it is difficult to observe the effect they might have on bottom-up earnings estimates for the future, because any relationship is masked by the economic cycle.
The key to sustaining the bull market is growth. Buybacks won’t save the day if underlying profit growth stagnates again in 2013 as it did in 2012.
Fortunately, the signs are pointing to a better year ahead.
This post was originally published by the BCA Research blog.