Understanding the story of stock buybacks

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Introduction

The S&P500 index has risen by about 4 times since the lows hit during the latest financial crisis. With it came a strong surge in share buybacks (or share repurchases). In turn, this shed light on corporate buybacks from all kinds of angles. Some say share repurchases are a manipulation of the stock market. Others claim they have been used to profit from by top executives. Yet others claim they are causing a corporate debt bubble. So, what is the real story behind record share buybacks? And what can we learn from them as investors and traders?

What are (and why) share buybacks?

A share buyback or share repurchase is a transaction whereby a company buys back its own shares from the market. Why would a company want to buy back its own shares? A few reasons. Form a practical standpoint, usually, share buybacks are accompanied by an immediate increase in the stock price. Why? Because it increases earnings per share (EPS) by reducing the number of shares outstanding. That usually signals to the market that the company thinks its stock price is cheap. From a more theoretical point of view, if a company has the same earnings, and the same dividends to split between fewer shares, that means more earnings and dividends per share for you as an investor.

From a company’s perspective, a common reason has to do with executive compensation. Many executives have their pay tied up to the performance of the company. Many times that comes in a form of share-based compensation. Hence, it is in the direct interest of the management to increase the share price of their company. Moreover, future equity-based financing will be cheaper for the company if the price per share is higher. These are only some of the reasons why a company would want to buy back its own stock in general.

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The big picture

Share buybacks have been increasing and hit record highs in 2018 (totaling over $800bn):

Source: Yardeni Researchbuyback

As a result, total shares outstanding of the S&P500 index have gone down:

Source: Yardeni Researchbuyback

And as it turns out, share buybacks have recently correlated quite well with the S&P500 index:

This chart can be turned into a strong argument if needed. For example, one could argue that buybacks have been driving the stock market rally. If true, you could then argue that it’s a manipulation of the stock market, or that companies have pushed up their earnings per share figures excessively which drove up share prices without good reason. Maybe it’s just a bubble? All kinds of interpretations are possible if implied that correlation means causation. However, that is not necessarily true. The logic being, as total earnings increase, companies have more money to do share buybacks in the first place. Moreover, the Trump corporate tax reform effective of 2018 has cut the corporate tax rate from 35% to 21%. This gave companies an extra boost to their after-tax earnings and cash.

If buybacks were indeed driving the stock market, then a substantial increase in buybacks in 2018 (right after the tax cuts) should be accompanied by a larger than a normal rise in those stock prices who have bought back the most shares, right? Let’s take a look at the S&P500 Buyback Index performance vs the general S&P500 Index since 2018. The S&P500 Buyback Index includes shares of companies who have bought the most shares relative to their market cap.

Source: Ycharts

buyback

As we can see, the Buyback Index has actually underperformed the general S&P500 index by more than 3% since 2018. This does not provide evidence that buybacks have been the major driver of the S&P500. Not to say that buybacks have not contributed to the rise in share prices, but it does seem like the perceived effect has been overstated.

Given this, we will take a look at 2 other popular beliefs regarding stock buybacks, and 2 interesting explanations for them.

1.) Popular beliefs

1a.) Buybacks are mostly funded by debt and will cause a corporate debt bubble burst.

Popular belief nowadays holds that because buybacks are mostly funded with debt, and corporate debt has been hitting all-time highs, it’s bound to burst. First, let’s take a look at the assumption that buybacks are funded with debt (you will see that many times financial corporations are excluded from the analysis – it is because they have relatively high leverage to normal companies, because of their business model, not necessarily meaning that they face financial distress because of it):

Source: Moody’s Analytics

buybacks

In the chart above we can see non-financial corporate net borrowing (debt issued minus debt repaid) vs non-financial corporate buybacks (yearlong). With some exceptions, we can see that in general, these two do correlate. What is also interesting is that just before the financial crisis of 2007, companies borrowed the most when interest rates were the highest (they were being raised from only 1% in 2004 to 5.25% in 2007 and 2008). We will get to this a bit later.

That said, as of recent, debt-financed buybacks, as a % of total buybacks have fallen to the lowest level since 2009:

Source: JPMorgan

buyback

In addition to buybacks, corporate debt levels have also been getting a large amount of attention. Why? because they have been hitting all-time highs not only in absolute terms but also relative to GDP.

Source: Moody’s Analytics

As we can see, the first line depicts corporate debt as a % of GDP, which is at all-time highs. However, the second line, the net corporate debt (debt minus cash), although rising, has not hit all-time highs yet. This is because companies have accumulated a lot of cash:

Source: Goldman Sachs

The chart above shows the rising cash to assets ratio of non-financial S&P corporations.

Also, since corporate profitability is a better metric to use comparing company indicators, it’s probably wiser to compare net debt (rather than debt) to profit, rather than GDP. Let’s take a look:

Source: DB

As it turns out, although increasing as of recent, net debt to profit levels have been on the lower end of the spectrum compared historically.

In general, the picture here is that although many companies tend to fund buybacks with borrowed money, they do have enough cash and profits to support that. Not only that, the interest rate that they’re paying for that debt is rather low, as we’ve been in a low-interest-rate environment for quite some time now.

1b.) Buybacks come at an expense of investment

Another popular belief is that because companies increase their spending on buybacks, they have to cut on investment as a result. For instance, if we take a look at buybacks plus dividends paid out as a percentage of reported earnings, we can see that they have recently come to close to or even more than 100% of those earnings:

What does that mean? That could be seen as the company spending its current earnings for dividends and buybacks alone or over their limits. So, if you’re spending 100% of your profits on buybacks and dividends, where is there space for investment?

Additionally, buybacks as a percentage of CAPEX (capital expenditures by the company) have increased significantly as of recent:

Source: Deloitte

That said if we take a look at R&D (research and development) and CAPEX spending together, as a percentage of sales, we can see that it has actually been above the historical average as of recent:

Source: Goldman Sachs

An interesting addition to the story is if we take cash spending as a whole and compare investment spending (CAPEX+R&D+M&A (mergers, and acquisitions)) to shareholder spending, we can see that investment for growth has accounted for more than 50% of total cash spendings historically, and also as of recent:

Source: Goldman Sachs

buyback

That said, however, in 1990-2000 the ratio of investment spending to shareholder spending was more like 2:1, whereas nowadays it’s closer to 1:1.

So, what does all that mean? First, most likely buybacks do not overcrowd investment, as companies invest as much as they need to. They take on all the profitable investment projects they can and that they see fit given the current economic environment. That said, however, since interest rates are low, and cash is plenty, while profitability is high, they can allow themselves to borrow to fulfill all of their needs.

The only question is, how sustainable are these earnings, and how would companies deal with a downturn, if it happened right now? If the Fed decides to lower interest rates in the longer run, we might not see that happen anytime soon.

2.) Interesting explanations

As we have taken a look at some popular beliefs regarding the effects of stock buybacks, let’s see some interesting explanations as to why these buybacks are increasing right now.

2a.) Buybacks as profit for executives and insiders

An interesting take on share buybacks is the view that top executives and insiders generally reap the profits of such operations. For one, as we have already mentioned, many times EPS or stock price are directly linked to executive and employee compensation. That could be in a form of cash, or in a form of stocks or stock options. Whatever the case might be, it is in the direct interest of the management to perform buybacks since they tend to increase the price of the stock and EPS at least immediately after the announcement. Not only that, as commissioner Robert J. Jackson Jr. has found out, insider selloffs of shares tend to happen just after a buyback announcement is made:

Source: SEC

 

In his own words, “On average, in the days before a buyback announcement, executives trade in relatively small amounts—less than $100,000 worth. But during the eight days following a buyback announcement, executives on average sell more than $500,000 worth of stock each day—a fivefold increase. Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement”.

This might be a plausible explanation as to why companies are increasingly turning to buybacks. In addition, this raises questions as to why you would sell your company’s stock if you are doing a share buyback, which signals to the market that your stock price is undervalued?

2b.) Buybacks as compensation for share dilution

Another interesting take on why buybacks have surged in recent times is provided by Yardeni Research. They claim that it simply happens because as profitability grows, share prices and employee compensations grow. As a result, companies increase their compensation in stocks for their employees. That actually adds to the pool of shares outstanding, and to counter that and counter the dilution of EPS, companies buy back their stock. The following chart can give a glimpse of what might be happening:

Source: Yardeni Research

The green line shows the gross issuance by companies which is how much stock the companies issue. The blue line shows buybacks. And the red line shows net issuance or net buybacks, which equals gross issuance (positive) plus gross buybacks (negative). The black lines show the recent trends. As it turns out, net buybacks paint a smoother picture of corporate buybacks (except Q4 2018), as they have been closer to par than gross buybacks. Also, while very volatile, gross issuance has been increasing, at the same time as buybacks have been increasing. That means more and more stock has been issued, with more and more buybacks happening. And that might just explain a part of the buyback story.

Discussion

We have talked a lot about why stock buybacks are increasing and touched upon some of the popular beliefs about them. However, what do they mean for investors and traders?

First, let’s get back to the correlation between the S&P500 index and stock buybacks:

Source: Credit Suisse

buyback

Similar chart as we have seen at the start of this article, but let’s look closely again. As the title of the chart claims, buybacks are greatest when stocks are priciest. Well, what exactly does that mean? First, the implication is this. If you think companies doing buybacks signal that they are cheap, think again. Most buybacks happened when the S&P500 was at its highest level. That might point to the fact that either companies don’t really know when the time is right to buy their own stock, and are wasting money borrowing it when the interest rates are higher than normal (as we have discussed earlier), or that they simply do not care, as insiders cash out just after buybacks are announced.

We have also touched upon the fact that companies spend more than what they earn in dividends and buybacks. Let’s take a look at a graph, similar to the histogram we’ve already seen in this article before:

Source: Yardeni Research

What this shows is buybacks+dividends as a percentage of operating earnings, historically. The yellow line is when the S&P500 was at its peak, in 2007, prior to the financial crisis. Basically, we are at a similar level in terms of the ratio to when the S&P500 was at its peak in 2007. And while it does seem worrisome, as I’ve already mentioned, the big unknown here is the Fed, which can fuel the stock rally again by decreasing rates.

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Conclusion

We have tried to look at the picture of buybacks and put the pieces of the puzzle together. While there is a lot of confusion and many unknowns in the story, it is clear that historically companies have not been good decision-makers as to when the stocks are cheap and when they’re expensive. While this might not be the most cohesive writing on my end, I hope this article gets you thinking about stock buybacks a little more, and what they might mean for the markets.

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