Europe's Buybacks? No Earnings Nirvana

S&P's Clive McDonnell tells why companies' stock buybacks haven't boosted share earnings and offers some advice for investors

Has the European stock-buyback binge really provided an earnings bounce? With a relative lack of growth opportunities and low stock prices, European share buybacks soared in 2005, according to Standard & Poor's.

With the overall number of shares trading on the S&P Europe 350-stock index increasing, the buybacks provided less of a boost, in terms of earnings per share, than they did in the U.S. Standard &Poor's interprets this as a plus for European indexes since European buybacks are not "artificially increasing earnings per share."

What are the implications for investors? S&P's Chief European equities strategist Clive McDonnell, the report's author, recently spoke with reporter Alex Halperin about the buyback binge, where investors should be looking for growth, why there are still opportunities in income stocks, and why the health-care industry could deliver on both counts.

Edited excerpts from their conversation follow.

With so much [ongoing] M&A activity, are these share buybacks the logical followup?

Not really. I don't necessarily see a link between the two. A lot of the M&A activity that we've seen has been dominated by private-equity investors as opposed to commercial buyers. I think that's because commercial buyers are a bit cautious about the valuations. But given the huge growth in their own cash piles, they have decided to raise their share buybacks as a way to improve shareholder returns.

They haven't been raising EPS to a proportionate degree. Why is that?

That's because there has been a net increase in the total number of shares outstanding, which is not at all unusual. Over time, we would expect the total shares outstanding for a company, or an index to rise. That's historically what happens.

The fact that the two are in balance almost suggests a bit of an equilibrium, and that contrasts quite considerably with the U.S., where we've seen quite a significant drop in the number of shares outstanding, for the overall Standard & Poor's 500-stock index, which has led to an artificial increase in EPS growth.

Do you see the European buybacks as accomplishing what they're setting out to do?

It's early days. There was a significant increase last year, and I don't have too much data so far this year. But I do admit that if you look at the top-performing sectors last year, [they were] in those areas that did not lead in terms of buybacks. It's a bit of a nuanced picture in that investors are willing to reward those companies that do have good growth prospects. But for those that have a bit of a question mark over their growth prospects, [investors] want to see a return in cash.

What happened last year was that some of the big cyclicals that could deploy their capital quite effectively, in terms of making new investments, were among the top performers. But I would suggest that that while the most defensive companies, that did increase their buybacks, weren't massively rewarded by investors, I think they would have underperformed to an even greater extent had they not engaged in the return of capital to shareholders via a combination of raising dividends and the buybacks.

Should investors look towards those sectors where there aren't buybacks as the smart bets for the moment?

It very much depends on what an individual investor's strategy is and also their view about growth. For those investors that are more income-oriented, they should definitely be focused on the sectors we think will continue to see buyback activity. Investors that believe growth can continue to surprise on the upside probably [should] focus on those sectors that are not seeing so much buyback activity with the implication that managers are actually investing in their business.

The only exception to that would probably be health care, where buyback activity didn't change at all last year and the sector has good growth prospects. But it has defensive qualities as well. It's a bit of a hybrid story at the moment, I would say. It very much depends on your view of the outlook.

Why does health care have better organic growth prospects than the other sectors?

The view our analysts have articulated is that it reflects a healthy product pipeline. Also, there have been a number of big mergers over the past 18 months. The sector has a reputation for paying out a healthy portion of its income out as dividends already. So while it didn't see any change in its buybacks last year, it's important to keep in mind that the payout ratio is already quite healthy for that sector.

I think the signal it's sending is that there are good potential organic growth opportunities. And maybe they're keeping their gunpowder dry for future acquisitions going forward.

Do any particular companies come to mind for these opportunities?We're not in a position to speculate on M&A activity in individual sectors. However, our analyst has recently upgraded recommendations on AstraZeneca (AZN) to 4 STARS [buy], and we've also got a number of other buys in the sector such as GSK (GSK), the biggest company in the sector.

On the other end of the spectrum are telecoms, where there have been many more buybacks. What sort of developments would spur greater growth [opportunities] in the industry?

From a structural point of view, the industry is maturing so it's not possible simply to create growth opportunities in a sector that is past its growth phase. Of course, there will be individual stories where management teams can create new opportunities but the sector overall is in its mature growth phase at the moment. It's a bit like the utilities sector in that it's got a high dividend payout ratio, also a high dividend yield.

I'd give you the same example for utilities: the sector is not really about growth, it's for income-oriented investors, utilities, that is, not necessarily telecoms because there are some risks remaining [for telecoms]. Within that, I would highlight that there are some growth stories among the smaller, more nimble players.

Such as?

One of our analyst's preferred companies is KPN (KPN), which is operating in its home market very competitively. But it has basically turned its business model inside out as a way to try and compete with some of the other upstarts in the markets. It appears to be having some success doing that.

You mention that there is also an increased holding in treasury shares by some companies. Is that a parallel phenomenon to the buybacks?

They are definitely related but there's not a linear relationship between the two. Specifically, what I mean is that while companies can buy back shares if they have permission from shareholder that does not automatically mean that you see a rise in treasury shares. Companies may decide to cancel the shares that they have acquired.

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