The Fed Unleashed A Mega Bullish Force For These Stocks

Wall Street banks are cheering like kids on Christmas morning.

In an unlikely move, the Fed gave them the go-ahead to buy $11 billion of their own stock. And America’s largest banks—including JP Morgan (JPM), Goldman Sachs GS , and Bank of America BAC —popped ~3-5% on the news.

Why so much fuss about buying their own stock?

Individual investors may not know this well, but buybacks have become a powerful tool for wealth distribution. And today, a lot of companies use them as a fill-in for dividends to pay back to shareholders.

In fact, buybacks are one of the reasons stock investors have gotten so rich since 2010.

Problem is, the Fed barred banks from buying back their own shares during Covid. And while America’s largest banks have hoarded the largest pile of cash since 2010 , they had few options for handing it out to investors.

But now that the ban is relaxed, the banks are set to “pay back” tens of billions of dollars in 2021.

I’ll explain how this works and what it means for investors in a moment. First let’s go over some nuts and bolts.

How public companies give back to investors

At some point, most public companies reach a point where they make more money than they spend. There are a couple of ways they distribute that cash to shareholders.

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The company can reinvest earnings and reward its shareholders through capital appreciation. For example, the company may choose to invest in technology or buy fixed assets such as equipment and real estate—aka capital expenditures (CAPEX).

If these investments turn out well, the business value grows, and so does the price of shares.

Another and more direct way is to cut a check (that is, pay a dividend). Many big, mature companies like Proctor & Gamble PG (PG)—whose growth is limited by nature—choose to pay dividends. Typically, they disburse up to 60% of their entire earnings this way.

Finally—and strange as it sounds—companies can “pay back” their shareholders by, well, buying back their own stock.

Why buybacks are good for other investors

Now you might be asking how is some company buying its own stock supposed to benefit me?

I know, buybacks may sound like just that, a company simply buying its own stock just as anyone else might. But under the surface, this transaction carries big implications for other investors.

Here’s a quick explanation from my earlier column on buybacks:

When a company buys back its shares, it pulls them from the open market. That means they’re no longer available for other investors to buy. This affects stocks in at least two ways.

For one, a buyback reduces the number of shares. As I said, stocks trade in terms of supply and demand. A reduction in the number of outstanding shares will lead to a decrease in supply and, in turn, an increase in price. Plus, the lower share count will increase the ownership stake of shareholders.

Second, pulling shares from the market improves a number of financial ratios investors look at.

For example, price-to-earnings ratio (P/E)—the most popular gauge of a stock’s value—uses the number of outstanding shares in its formula. The fewer shares, the lower the ratio.

Or earnings per share (EPS), the most cited metric from earnings reports. Like P/E, the reading of this measure is based on the share count. The fewer shares there are, the better the reading.

In other words, buybacks reward shareholders in two ways. First, they reduce the supply of shares, which inflates their price. Second, they “touch up” the stock’s financial ratios, which makes it more attractive—i.e. lower P/E and higher earnings per share (EPS).

The dividend of the 21st century

In the past, dividends have been the go-to payout to shareholders. But at the turn of the century, buybacks began phasing them out. And in the past 15 years, they have largely outgrown dividends.

Since 2000, US companies have paid out to investors 3X as much as during the period 1971-1999. And a recent NBER study found that this surge in payouts comes entirely from share buybacks.

In particular, the buyback frenzy took over the S&P in recent years. Before Covid, not only did they nearly double dividend payments, at some point they also outgrew capital investments, as you can see here:

In fact, US companies gobbled up so many of their own shares that they have become the biggest stock buyers, as you can see here:

There’s no way I can overstate the role that buybacks play in the stock market. Although not well understood, in the last decade they’ve quietly become one of the biggest drivers of stock prices.

America’s largest banks will pay back tens of billions next year

Now, let’s look at the news from this whole new perspective.

The Fed let America’s six largest banks buy back as much as $11 billion worth of shares this quarter. That’s a lot, but there’s a good chance it’s just the tip of the iceberg.

For example, JP Morgan (JPM) alone is drawing up to buy $30 billion of its shares in 2021. For perspective, that’s 20% more than its previous record in 2019. (When JPM soared a record 42% in a year.)

And all this should be music to investors’ ears for a couple of reasons.

For one, the Fed tips off that banks may have set aside way more cash than this crisis will call for. And part of this pile could quickly end up in shareholders’ pockets through buybacks.

In fact, the banks have been paying out just 30% of their profit to shareholders in dividends. And a Bloomberg analysis shows the Fed’s “allowance” can bring their payouts to 100% of banks’ average net income over the past year.

Second, Wall Street banks have largely lagged the market during Covid. But buybacks and a growing appetite for recovery stocks (including banks) could launch bank stocks into a catch-up rally next year.

“That’s been one of the real missing points to the bank stocks: their ability to go in and buy back their own stock,” Gerrard Cassidy, Head of US Bank Equity Strategy at RBC Capital Markets told CNBC.

The renowned Wall Street analyst later added: “This is one of the reasons bank stocks should be owned.”

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