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Last month, IBM approved a $15-billion increase to its repurchase program, prompting a 2.7-per-cent share spike the same day. But the announcement came soon after the company posted a decline in sales for the sixth straight quarter.MARK LENNIHAN/The Associated Press

Like a rich uncle, corporate America has been buying the affections of investors, by way of a simple financial manoeuvre: the share buyback.

Ever since the market began to recover in 2009, companies flush with profits have poured their cash reserves into buying back their own stock.

But critics question whether the buyback binge may be lulling investors into a false sense of security. Companies that use share repurchase programs can boost their earnings per share even if profits are stagnating. It's not clear if shareholders are any better off as a result.

Buybacks have been an important contributor to the monumental stock rally that is still unfolding, but there are signs the trend has crested. Some market watchers are now recommending that investors consider rotating out of stocks that rely heavily on buybacks and focus more on those companies investing for growth.

"I'm watching for signals where the market starts rejecting companies growing their earnings [with buybacks]," said Mike O'Rourke, chief market strategist at brokerage firm JonesTrading. "I think we're very late in the cycle of companies doing this."

Like any severe downturn, the latest recession forced the corporate sector to cut costs and capacity to ride out the crisis. As profitability recovered, many of the slimmed-down survivors began to generate mountains of cash. But reluctant to invest in an uncertain economic climate, they turned to the share buyback as a quick way to dispense cash reserves and placate investors.

Repurchase programs reduce a company's outstanding share count, giving remaining shareholders ownership over a greater portion of earnings. Earnings per share magically increase even if overall profits don't, typically giving an instant jolt to share price.

In the four years since the market bottomed in March, 2009, up to last spring, U.S. companies bought back more than $1-trillion (U.S.) of their own stock, according to Rosenblatt Securities.

The S&P 500 Buyback Index, which tracks the performance of the 100 S&P 500 stocks with the highest buyback ratio over the past year, has gained 42 per cent so far this year. That trounces even the S&P 500, which is in the midst of a historic year, up 27 per cent since January.

Even so, investors should beware the buyback.

"For this to be a more sustainable earnings cycle, you need to have companies invest for growth and not just buy back all their stock," said Barry Knapp, a strategist at Barclays Capital.

International Business Machines Corp. is a fine example of what share buybacks can – and can't – do. Last month, the tech giant approved a $15-billion increase to its repurchase program, prompting a 2.7-per-cent share spike the same day. But the announcement came soon after the company posted a decline in sales for the sixth straight quarter. The bad news extended across a number of IBM's divisions.

"The news and trading action in IBM personify what is unhealthy about the current environment," Mr. O'Rourke said at the time, pointing to IBM's "financially engineered earnings growth." Those who share that view worry that IBM is more concerned with supporting its own stock price than with improving operations.

The fact that IBM's share price is down 6 per cent on the year may be evidence that the appeal of the buyback is beginning to wear thin. "Confirmation of that signal will occur when such buyback announcements are met with less fervour," Mr. O'Rourke said.

Many investors may not fully understand that declining share counts permit companies to present healthy growth in their earnings per share despite slow growth in the bottom line. While S&P 500 companies posted revenue growth of 3.5 per cent in the third quarter, according to a Reuters report, earnings per share rose by 5.7 per cent. Almost all of the discrepancy can be explained by share repurchase programs, the report said.

For their part, managers have good reasons to like buybacks.

They are an efficient way to give investors a cut of the approximately $3-trillion in cash reserves sitting on balance sheets, said Ronald Dottin, a quantitative analyst at RBC Capital Markets. Management could boost dividends to distribute cash, but a higher dividend represents an implied commitment, Mr. Dottin said. Investors tend to expect dividends to continue, while buyback programs can generally be cut without consequence to share price.

Meanwhile, low borrowing rates mean companies can cheaply finance buybacks: Consider Apple Inc., which has raised debt for its repurchase program, which activist investor Carl Icahn has encouraged the company to raise to $150-billion.

"That's the amusing thing – both institutions and individual investors love [buybacks]," said Howard Silverblatt, senior index analyst at S&P Dow Jones Indices LLC. Despite the obvious concerns, buyback announcements are met with nearly indiscriminate market approval.

That is at least, in part, a product of an unusual investing environment. With short-term interest rates capped by the U.S. Federal Reserve, investors have been pushed out of fixed income markets. Instead, they've hunted for yield in equities bearing bond-like characteristics, including high buyback yield.

"A year ago, we would have told investors, 'companies that are aggressively managing their cash flow in a shareholder-friendly way, that's where you should be,'" Mr. Knapp said. In those circumstances, he favoured utilities and health-care stocks.

"We think we've gone through the maximum point of preference for yield," he said. Buybacks appear to have peaked in the second quarter last year with repurchases of $508.1-billion, according to Fed data. Buybacks amounted to $344.8-billion in the second quarter of 2013.

For the time being, buybacks will continue to be a big part of the discretionary uses of cash flow. Investors can capitalize on the lingering trend while limiting exposure to aggressive repurchasers by buying those top year-to-date performers of the buyback index that also have a decent dividend. Among the top 10 companies with dividends yielding at least 1.5 per cent are GameStop Corp., Assurant Inc., Western Digital Corp. and Ameriprise Financial Inc.

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