Oh, no! The buyback bid may be fading!
What began as rumblings from disgruntled skeptics has, over time, morphed into something of an outpouring of derisive analysis from all corners with regard to the rampant proliferation of financial engineering by corporate management teams.
In a world governed by ZIRP and NIRP, the temptation to leverage the balance sheet in pursuit of likely ephemeral EPS gains is hard to resist and when management’s compensation is linked to equity, the stage is set for prudence to be summarily tossed aside in favor of debt-funded buybacks.
The main worry here is that corporates have leveraged themselves to the hilt in an environment characterized by an insatiable hunt for yield among investors. In order to keep the ravenous hordes sated, corporate management teams have simply met demand with more supply and in many cases used the proceeds to buy back shares in a “virtuous” loop that not only inflates the bottom line, but also boosts management’s equity-linked compensation. See? Everyone’s a winner!
Of course issuing debt to buyback your own inflated shares is “clearly nonsense” – as SocGen’s Andrew Lapthorne put it earlier this year, and this practice has led directly to high corporate leverage and a disproportionate share of U.S. equity demand being accounted for by the corporate bid.
Meanwhile, thanks to the very same central bank largesse that made debt-funded buybacks so attractive in the first place (i.e. low rates and an insatiable hunt for yield among investors), credit markets aren’t punishing companies who employ financial engineering, leading to a disconnect between spreads and leverage ratios.
Recently there have been questions about whether this dynamic has reached a limit in terms of how much longer it can go on, especially since management teams, if they’re any semblance of sane (an open question), will start to question whether buying back shares at record highs is a good idea.
Well consider this from BofAML:
With even the late reporters 2Q results in by now, data from US non-financial high grade issuer cash flow statements shows that companies have again reduced spending on both share buybacks and acquisitions during the quarter (Figure 1, Figure 2). This spending has been trending down as a share of free cash flow as well (Figure 3). The decline is notable because buying your own or other company equity is typically the biggest drivers of leverage for the high grade market (Figure 4). The reason for the decline is likely a combination of richer equity valuations as well as better growth globally that allows companies to deliver EPS growth without resorting to financial engineering. Finally, robust supply volumes in the first half despite decelerating cash needs supports our view that issuance was front-loaded this year.
Aggregate data for our universe of high grade issuers shows expenditure on net share buybacks declining from $84bn in 4Q-16 to $73bn in 1Q and $64bn in 2Q. Similarly spending on acquisitions fell from $99bn in 4Q-16 to $72bn in 1Q and $62bn in 2Q.
That’s ok, maybe we can just send a nice letter to the SNB and/or Norway’s sovereign wealth fund and politely ask them to fill the void.