Ahhhh, buybacks. The equity-linked-compensation-inflating music to soothe a savage market beast.
Buybacks have of course been at the top of investors’ minds in 2018, as the windfall from the Trump tax cuts is generally expected to be plowed into shareholder-friendly initiatives (as opposed to, say, wage increases) thus putting between $600 billion and $840 billion (depending on whose estimates you’re inclined to believe) worth of plunge protection under the market at a time when geopolitical jitters and other concerns have conspired to weigh on sentiment.
We (and everyone else) have covered this exhaustively. Earlier this month, we highlighted a Bloomberg interview with SocGen’s Andrew Lapthorne, who regular readers know is no fan of companies borrowing money to repurchase their own inflated shares, an exercise he has variously characterized as “clearly nonsense”. Here’s the money quote from a note out last year:
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.
In the above-mentioned Bloomberg interview, Lapthorne had the following to say about the state of corporate balance sheets 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. It’s not like you have to dig deep to find a problem.
Right, and as usual, all of this comes back to accommodative policy, which artificially suppresses borrowing costs, incentivizing companies to employ financial engineering and jolting demand for all the new supply by creating a desperate hunt for yield among investors.
Ever since 2013, S&P 500 companies have bought over $400 billion of stock back each and every year.
Let’s take away the 2018 estimate and have a look at the past decade of stock buy back data.
Apart from 2007, companies have been hoovering up stocks at a record pace. Eegads. Combined with the Barron’s cover, buyback stats are flashing red.
Comparing apples to apples
But as Lawrence Hamtil reminded his followers the other day, buybacks need to be adjusted for market capitalization. Once I saw his comment, I instantly knew he was correct. As the market keeps rising, the total dollar value of buybacks will also naturally rise. It makes little sense to look at buybacks in absolute terms, but instead we should be focusing on buybacks relative to total market capitalization.
So I set about figuring out what this chart looked like as a percentage of S&P 500 market cap.
Suddenly, it’s not nearly as scary. In fact, 2017 was the second lowest amount of buybacks as a percentage of market capitalization. And even Goldman Sachs’ $650 billion estimate for 2018 (from the graph above titled “Scooping Up Stock”) only equates to 2.25% of total market capitalization at current prices.
Even though I want to join the chorus of pundits worrying about the record amount of buybacks, I can’t bring myself to sing the tune. When I look at the stats, it gives me comfort, not concern. In 2007 company treasurers bought almost 5% of the market cap. We are currently running almost half of that.
On Friday, Goldman is out making that same observation in an update called “Assessing the efficacy of spend.” Here are a couple of brief excerpts:
The pace of share repurchases is poised to accelerate in 2018, stemming two years of declines. Our Portfolio Strategy team forecasts executions to reach $650 bn (+25% yoy) this year on the back of strong corporate cash flow and the one-time boost associated with bringing back overseas cash post tax reform. In addition, year-to-date authorization activity is already close to $450 bn (vs. $274 bn at this point in 2017 and $307 bn in 2016), with Tech accounting for over 50% of the authorizations this year. The current run-rate suggests authorizations are on pace to hit $900bn in 2018, which would surpass 2007’s previous record and represent a +30% increase yoy.
That said, it is worth noting that while the value of spend has been high, it has significantly lagged behind market appreciation in recent years. As a result, we find that when we scale by percent of market cap, buybacks have actually been running below trend the last two years and only just recently show signs of increasing (See Exhibit 2). The same is true of authorization activity, which hit five-year lows as a percent of market cap at the end of 2017 and is still below average.
The bank goes on to cover some well-worn territory and make a series of intuitive and thus not entirely interesting observations, but the numbers are fresh and the projections are up to date, which makes this exercise highly useful.
Goldman notes that aggregate spend doesn’t translate directly into share count reduction. That is, all else is obviously not equal, so to speak (think employee stock grants and valuation). The question then, is this: which companies have had the most “success” at reducing their share counts?
The answer to that is found in the following table (you can see the criteria in the chart header and infer the rest from the column labels):
Looking ahead, Goldman applies the same criteria to determine which companies are likely to be the most “successful” buyers of their own shares through the end of 2019:
The bank does go on to warn that corporate management teams are not generally very adept when it comes to timing these purchases and they also present an IRR framework for assessing the relative merits of buying back shares as opposed to putting cash to work on things that don’t include effectively perpetuating labor ——–> capital transfers.
We won’t delve into that here, but before we close this post, we would also note that Goldman hints at what the above-mentioned Andrew Lapthorne has been pounding the table on for some time, which is that eventually, equity investors are going to stop rewarding balance sheet recklessness (Goldman just looks at the “lackluster performance” of the buyback benchmarks since mid-2016).
Recall this from Lapthorne on performance:
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 in the same note from which that excerpt is taken, “if your shares are bought off you, then you typically need to reinvest them.”
Whatever you believe about this debate, don’t let it be lost on you that in and around the February correction, Goldman’s buyback desk had the two most active weeks in its history, with executions jumping some 80% YoY.