As the economic recovery continues, corporate earnings are surging as businesses grapple with outsized levels of pent-up demand. In the second quarter alone, earnings for S&P 500 companies have exceeded analyst expectations with year-over-year growth a whopping 90%! For the full year, earnings are estimated to grow 40% – the largest annual increase since the Great Financial Crisis.

While the recovery remains uneven globally – due to the COVID-19 Delta variant – the robust growth in earnings and cash flow from U.S. corporations afford management teams the opportunity to resume shareholder friendly initiatives. Goldman Sachs estimates U.S. companies have announced more than $680B in share buybacks in just the first half of 2021.

What are share buybacks?

Share buybacks involve the corporate repurchase of the shares outstanding of a business. While management teams can employ several different approaches, share repurchases are traditionally conducted in the open market.

The primary motivation for share buybacks is to return capital to shareholders. In some cases, companies will initiate a share buyback program as means of offsetting the dilution of employee stock options and stock grants.

Are share buybacks good?

As stewards of investment dollars, the goal for management is to deploy cash where the highest return on capital can be achieved in order to create shareholder value. As a shareholder, stock buybacks allow you – as an owner – the opportunity to own a higher ownership interest in the business.

The math is simple – if you own 10 shares of a company with 100 shares outstanding, you own 10% of the business. If the company repurchases 10 shares through a buyback program, your percentage ownership becomes 11.1%. While some may argue stock buybacks are a form of financial engineering through the manipulation of earnings per share, owning more of a business as a shareholder is a great thing! Here’s how:

In Berkshire Hathaway’s most recent annual letter, Warren Buffett outlines the power of share repurchases with his position in Apple Inc. In 2016, Buffett started purchasing shares of Apple with a cost basis of $36B and amassed a 5.2% ownership stake. Despite reducing his ownership position by roughly $11B in 2020, his ownership stake actually increased to 5.4%. You might wonder how…Apple’s incredible business model throws off tens of billions of dollars in free cash flow on an annual basis. The amount of cash Apple generates not only allows it to reinvest back in its business, but also increase the cash it holds on its balance sheet and employ an aggressive share repurchase program. Long-term shareholders of Apple continue to increase their ownership in the company by simply doing nothing.

Another great example of a business with a disciplined share repurchase program is AutoZone, the largest auto parts retailer in the country. From 2000 to 2020, the company grew revenues by 181% and net income by 549%. Through a disciplined share repurchase program, the company reduced its shares outstanding by 81%. Over the same time period, earnings per share have risen by an astonishing 3,500% and the share price has appreciated by over 4,000%!

Not all buybacks are created equal

The most successful companies with buyback programs typically enjoy strong business models, and most importantly, are supported by excess levels of free cash flow across economic cycles.

Companies employing considerable amounts of leverage to support a buyback program should generally be avoided. The airline industry came under fire as the companies sought financial support from the government as COVID resulted in revenue declines of near 90%. Over the last several years, rather than maintaining adequate levels of leverage, many airlines piled on tens of billions of dollars of debt on their balance sheet while employing aggressive share repurchase programs. In this case, share buybacks have done little to create shareholder value.

What does all this mean?

Demand remains strong across every sector of the market – companies are steadfast in capitalizing on the surge in business activity, overall resilience of the U.S. consumer, and accommodative fiscal and monetary policy. Longer term, the prospects for higher share repurchases is an added catalyst for higher earnings and further growth in the equity markets.

As part of our investment approach, we favor companies employing a prudent share repurchase program. Buybacks are a powerful tool and an excellent form of creating long-term shareholder value.