Listen, SocGen’s Andrew Lapthorne is going to make you a believer in the idea that spreads are disconnected from measures of corporate leverage if he has to kick down your damn door and scream it at you, ok?
Regular readers are probably some semblance of familiar with Andrew’s work and he talks (a lot) about leverage and the risks inherent in lack of balance sheet discipline.
Perhaps our favorite Lapthorne quote is his straightforward assessment of companies who issue debt at artificially suppressed borrowing costs in order to implement bottom-line-inflating buybacks at nosebleed equity valuations:
As we have long pointed out, the reason for [the] increase in debt is largely down to financial engineering — aka share buybacks. Borrowing money to buy back your elevated shares is clearly nonsense.
Right. Or actually, it’s “clearly nonsense” if you care about doing the responsible thing, but it’s “clearly” awesome if what you care about your equity-linked compensation and adopt a myopic approach to management. Look on the bright side!
The other thing about buybacks is they act as real-life plunge protection for the broader market in a scenario where systematic strats are forced to de-risk and long investors are failing to BTFD. Just ask Goldman, whose buyback desk had its most active two weeks in history during the February rout. Recall this from a February 24 note:
Tax reform and the recent market correction will fuel 23% growth in buybacks to $650 billion. The Goldman Sachs Corporate Trading Desk recently completed the two most active weeks in its history and the desk’s executions have increased by almost 80% YTD vs. 2017.
Here’s a fun chart:
Goldman sees something on the order of $650 billion in buybacks in 2018 but JPMorgan is even more optimistic, calling for more than $800 billion in repurchases.
Ok, so you might remember that back in August, Lapthorne went looking for proof of whether buybacks in fact boost the shares of the companies who institute them and his conclusion was that there’s not much evidence for that contention. Recall this:
We have measured the coincident performance of companies that buyback their shares and we can pretty much conclude that there is no performance advantage whatsoever during the period they buy back their share. We have looked at this in a variety of formats. We have looked at quarterly and annual share buybacks versus quarterly and annual share price performance. We have analysed this on an absolute, industry and sector relative basis. We have looked at average performance, sector relative performance, normalised performance. We have essentially thrown the back-testing kitchen sink at it and cannot find anything to suggest that doing a share buyback positively affects the share price of a company.
That of course is not to suggest that buybacks-gone-wild don’t help the market overall. As Andrew reminded investors, “if your shares are bought off you, then you typically need to reinvest them, and we estimate that the US has had 17.5% of its market cap bought back over the past 6 years.”
Well in an interview with Bloomberg out this week, Lapthorne takes up this issue again in the context of what he calls “grotesque” corporate leverage in the U.S.
“Leverage in the U.S. is grotesque for this stage of the cycle [and] at the moment you’ve got peak leverage at peak prices,” he mused, adding that “it’s not like you have to dig deep to find a problem.”
No, you don’t. But you do have to “dig deep” to muster the courage to trade against the crowd when everyone is still scrambling down the quality ladder in search of yield as central banks keep risk-free rates glued to the flatline. That’s what enables the buyback bonanza and keeps credit spreads disconnected from measures of leverage and it won’t be until central banks begin to pull back on QE in earnest that spreads begin to reflect company specific and sector-level risk. That’s when the zombies problem comes into play.
Anyway, Andrew is worried that a return of credit volatility could destabilize markets more broadly and he’s not convinced buybacks are going to be a cure-all. Here’s Bloomberg, paraphrasing him:
Lapthorne doesn’t see buybacks as a panacea for markets. He said companies that announce them but don’t follow through outperform those that do. The average loss from share repurchases is about 5 percent, Lapthorne estimates. To him, the action of borrowing money to get a short-term boost in earnings-per-share is often motivated by executive compensation in the U.S.
That’s probably true and to the extent the borrowing binge is indeed motivated by the desire to buyback shares and boost executive compensation, that leveraging of the balance sheet is going to come back to haunt some of these companies…
…and bigly.
The research quoted here merely supports earlier research dating back into the early 1960s. One of my PhD advisors wrote his own dissertation on the subject back then and came to the same conclusion presented here, backbacks are essentially a net zero. The thing I can’t quite get in today’s buyback culture is why these silly corporations are buying their stocks at the top of the market. The logic forty years ago was that when stocks were cheap companies would buy them back at less than their intrinsic value and effectively reap a gain. The fact that such a gain is rarely realized seemed to be immaterial. One of the effects in the current buyback culture is the massive reduction in corporate equity they cause. There are now many S&P 500 companies that have balance sheets with little or even negative shareholders equity. Repurchased stock retained by the firm as treasury stock must be subtracted from equity on the books. If any of that stock is retired, equity is permanently reduced. Both actions have the effect of causing dramatically increased leverage ratios. At some point when firms like Colgate-Palmolive and Kimberly Clark, for example, show up with negative, credit rating agencies like S&P are going to have to start recognizing that with liabilities nearly as large or even larger than the firm’s assets, they are no longer strong credits. As H has pointed out repeatedly, BOJ’s massive equity buying has created some very weird consequences for liquidity for some Japanese stocks. Similarly, massive buybacks for some companies have created a circumstance that sure looks like a technical bankruptcy duck. I don’t yet have numbers on this phenomenon, but at the current pace of buybacks it could become serious. Remember, debts can’t be paid back out of a company’s market value. Actual balance sheet money is required.
It’s all very sad. It’s yet another consequence of the persistent availability of ultra cheap debt. Right now it’s being blatantly and flagrantly abused. We are in June now, and I frankly don’t see anything in the way of true motivation by our monetary policy regulators to motivate a burn off debt. (Ie, a persistent normalization of interest rates).
It’s a perpetual procrastination exercise on the part of politicians, fiscal managers, and monetary policy regulators to avoid the unthinkable: a large leverage based correction in equity valuations. I don’t even see the Fed as truly being vigilant at this point in normalizing the balance sheet and FFR for the long term, because the repercussions of such actions would be so painful for equity markets and the economy as a whole, and their political independence is being infringed upon by outside interest. It’s sad, but we are falling into the very same trap that Japan finds itself in now.