June 2, 2014 - Make the Buyback Craze Work for You
Stock buybacks have been quite the rage recently on Wall Street. Many companies have made big buybacks with S&P 500 companies buying back about 3.1% of their outstanding shares over the course of 2013. When a company buys back shares, all the existing shares should rise in proportion to the buyback.
Express Scripts (ESRX) trades at $71.09 a share and has a market capitalization of $55 billion. Express Scripts ships prescriptions directly to consumers as the largest mail-order pharmacy-benefits manager. The company had 2.3 billion in buybacks during the first quarter. As buybacks materialize the stock price should rise, as 2.3 billion in buybacks represent about a 4.1% jump in the stock price. If this were to all happen one day (when nothing else happened to affect the price) you should expect the stock to rise to about 74.06. Of course in reality there are many other factors affecting the stock every day and therefore isolating any particular move can be difficult. Stocks can also rise before hand in anticipation of the buyback happening, and option premiums can adjust due to expectations.
Buybacks usually happen slowly over time, as it takes time to buy all that stock without driving up the price. Companies love to announce buybacks, but they don't always follow through. Sometimes the company decides it wants to use cash for other purposes, or stops buying as the share price goes out of the target range. Companies have learned that investors like to hear about stock buybacks and pay little attention if they do not buy back all the shares they were permitted to. Keeping some extra cash available to announce the next buyback also allows the company to both support the stock in the long term and announce a bigger buyback potential next time.
When buybacks happen, option strikes are not adjusted. It may not be completely fair, but when the company buys its own stock, prices rise providing a slow lift to the shares. There are a lot of other factors that affect stocks such as market trends, inflation, revenues, and earnings. Buybacks are just one factor, but investors might want to position their investments that could be helped by buyback activity.
Not all companies actively pursue buybacks. This is definitely a strategy for companies that are making money and do not have a lot of great uses for all the additional capital. If you invest in a company doing buybacks they are likely in a mature industry that produces a significant amount of profit. Share buybacks also show the company executives believe the stock is still a good value and worthwhile investment. It can also mean they do not see expansion (in the current environment) as the most advantageous option.
Chart courtesy of stockcharts.com
Looking for a trade on Express Scripts (ESRX), the November 72.50 call catches our attention. The call has a bid of 3.25 meaning you can buy the stock at 71.09 and enter a buy-write trade at 67.84 (71.09-3.25). The covered call has a 6.9% assigned return over 177 days for a 14% annualized return rate (for comparison purposes only). The trade has 4.6% of downside protection and does not pay a dividend. The stock is rated a four STARS buy at S&P. Sales have been growing rising from 24 billion in 2009 to $104 billion in 2013 as it has delivered a lot of prescriptions directly to the people who need them at home. In 2013, EPS came in at 2.31 a share, but are expected to double in 2014 as the company finalizes the merger of Medco Health Solutions. Things are clearly feeling good at ESRX and with the buybacks the stock could rise a little more. While the stock should rise about 4% with all the buybacks, a covered call could target a 6.9% return over the next six months or an annualized return rate of 14%.