Believe it or not, the market is shrinking. Not in value, but in sheer number of issues trading. Record corporate earnings and huge cash balances aren't just going towards M&A and dividends, but share buybacks as well. A variety of global firms have taken to buying up their own stock and the S&P 500's divisor, a measure of outstanding shares, shrank by 0.6% last quarter. This is the first drop since March 2009. While not all buybacks are created equal, the recent surge in this activity bodes well for shareholders and investors can use them to their advantage. (For related reading, see A Breakdown Of Stock Buybacks.)

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Low Interest Rates Equals Surging Growth

Firms within the S&P 500 purchased more than $437 billion worth of their own shares during 2011, a 46% increase over 2010. Analysts think the surge in buyback activity is due to low interest rates. As more baby boomers and investors hunger for income, raising capital via bonds has become a cheaper option for many companies.

According to Bloomberg, corporate debt sales rose 3.2% to $800 billion in 2011, exceeding stock offerings by the widest margins since 2008. Microsoft (Nasdaq:MSFT), for example, has been using its AAA rating to issue debt solely for that purpose. In addition, analysts cite a lack of good M&A opportunities as another reason for the growth in buyback programs.

There certainly is some incentive for firms to buy back their shares. The repurchases shrink the total float amount of shares and the value of each outstanding share increases. Earnings per share (EPS) and returns on equity are enhanced and based on the P/E ratios; the company that completes a buyback is now less expensive than it was prior to the repurchase, despite the fact that there was no change in earnings. Analysts at S&P predict that 97 members of the S&P 500 will enjoy a boost to EPS of at least 4% based exclusively from repurchases alone during the current quarter.

Unlike canceling dividends, which can send share prices plummeting, announcing a buyback program then reneging on it has generally little effect. This makes them great programs to run in volatile markets. With huge amounts of uncertainty facing the global economy in 2012, buyback activity should surge throughout the year. When growth is hard to come by, the "instant" earnings per share boost is hard to beat. (To learn more, check out How Buybacks Warp The Price-To-Book Ratio.)

Playing the Surge in Activity
Not all buyback programs are effective. For example, JPMorgan (NYSE:JPM) spent around $4.4 billion to repurchase shares in the third quarter only to see its stock fall shortly after. However, equity valuations are cheaper than they were four years ago and these programs should produce better results. For investors, adding a dose of buyback muscle could produce great results.

The PowerShares Buyback Achievers (ARCA:PKW) tracks an index of firms that has repurchased at least 5% or more of its outstanding shares for the trailing 12 months. Top holdings in the exchange-traded fund (ETF) include Wal-Mart (NYSE:WMT) and Bristol-Myers Squibb (NYSE:BMY). Similarly, the Trim Tabs Float Shrink ETF (ARCA:TTFS) uses a more actively managed approach to find buyback buys.

Healthcare firms remain a huge proponent of these programs. Recently, biotech Amgen (Nasdaq:AMGN) issued $6 billion of bonds and purchased around 9.5% of its outstanding shares in December. The stock has gained around 18% since the announcement. Likewise, AstraZeneca (NYSE:AZN) announced it would double its buyback program to $4 billion. Shares of the drug maker currently trade for a dirt cheap P/E of around 6.6.

The Bottom Line
Record corporate profits and super low interest rates are resulting in a shrinking market environment. Share buybacks are on the rise and analysts predict 2012 will see more of the same. For investors, finding companies that do these programs right could be a great portfolio addition. The previous picks, along with L-3 Communications (NYSE:LLL), make ideal choices. (For additional reading, check out 6 Bad Stock Buyback Scenarios.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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