When it comes to politically-sensitive market topics, you’d be hard-pressed to find an issue that garners more attention among enterprising lawmakers than buybacks.
Criticizing corporate cash usage is a great way to prove your liberal bonafides and that goes double and triple in the current environment, characterized as it is by relentless scrutiny of how management teams “spent” the windfall from the Trump tax cuts.
Admittedly, I’ve soured a bit on this issue or at least soured on the idea that anyone who fancies themselves a keen observer of markets is compelled to weigh in at least once a week on the purportedly nefarious practice of eschewing other uses of cash in favor of EPS-inflating share repurchases.
To be clear, there is little question that post-crisis monetary policy and the tyranny of the next earnings report are at least partially responsible for a buyback bonanza that has manifested itself in a situation where the corporate bid has for years comprised the largest source of US equity demand. Additionally, there is no question that the tax cuts incentivized still more buybacks. Further, money spent buying back shares could have been spent on other things, because that’s how money works. Finally, it is by no means obvious that leveraging the balance sheet in order to repurchase shares at the tail-end of the longest bull market in history is advisable, even if the cost of debt is very low.
All of that said, it has become impossible to separate political grandstanding from honest criticism when it comes to demonizing buybacks. On the other side of the debate, it’s equally difficult to discern whether those who malign political grandstanding are actually interested in absolving buybacks with good arguments or are in fact just writing to express their disgust with the hyper-politicizing of the debate in general. The former is a worthwhile enterprise, while the latter is tantamount to saying nothing, because in today’s America, every issue is hyper-politicized.
And so, I’ve generally erred on the side of letting everyone else sort this out by shrieking at each other on Twitter, the go-to venue when you want to express yourself in terms that you doubtlessly would be too shy to use were the debate taking place in person.
But, given that he showed up on CNBC this week to try and dispel what he thinks are popular misconceptions, I thought I’d highlight some passages and visuals from a note by Goldman’s David Kostin, who isn’t sure you (where “you” means “everybody”) understand everything you need to understand when you set out to castigate share repurchases.
First, Kostin notes that between capex and R&D, growth investment has “accounted for the largest share of US corporate cash outlays every year since at least 1990.” Here is a bit more color from the note, dated last week:
Growth investment has accounted for the largest share of US corporate cash outlays every year since at least 1990. This fact is contrary to the popular belief advanced by some politicians that buybacks dominate corporate spending. For the past 30 years, corporate cash spending devoted to capital projects and research and development initiatives has consistently equaled roughly 10% of sales. During 2018, S&P 500 firms increased capex and R&D spending by 13% to $1.1 trillion, equal to 11% of annual sales.
Next, Goldman reminds you that returning cash to shareholders is “not a new phenomenon.” Rather, it’s been going on for at least the last several years, where “several” actually means 139 – years. It’s true that the composition of those payouts has changed, but since 1880, the average S&P 500 cash return payout ratio (i.e., dividends + net buybacks / net income) is 73%. We’re above that now, but not by a margin that one would consider “alarming”.
After noting that “the number of S&P 500 firms repurchasing at least some of their shares during the prior 12 months has risen from 196 in 1992 to 424 in 2018”, Kostin reminds you that explaining why management teams over the past two decades have embraced buybacks versus dividends is fairly straightforward – you can stop spending cash on share repurchases without suffering the kind of backlash that generally accompanies a dividend cut. In an environment where earnings volatility is high, that kind of flexibility is highly desirable.
“When earnings drop sharply, managements can easily reduce the cash spent on buybacks without disrupting dividend policy”, Kostin writes, adding that by contrast, “investors expect steady growth in regular dividends and do not take kindly to firms that cut dividends per share.”
Kostin goes on to provide a straightforward assessment of the impact of tax reform on buybacks, calling share repurchases “an efficient way for many companies to use repatriated funds.” Here’s the money line from that section:
In 2018, buyback spending jumped by $279 billion or 52% above the prior year’s level. Just 20 stocks in the S&P 500 index accounted for 38% of the $819 billion in aggregate cash spent to repurchase shares. However, those firms represented fully 69% of the overall increase in share buybacks! Unsurprisingly, these companies also had the largest amount of earnings trapped overseas.
Finally – and this is where the rubber meets the proverbial road – Goldman dispels the notion that perverse incentives are behind buybacks. Or at least the bank makes a run at dispelling that notion.
“One of the greatest misconceptions in the public discourse surrounding corporate buybacks is the belief that managements only repurchase stock in an attempt to inflate EPS and meet incentive compensation targets”, Kostin writes. That’s a bit of a strawman (i.e., I’m not sure it’s accurate to say that anyone believes the “only” reason companies repurchase shares is to inflate the bottom line and equity-linked compensation), but it captures the gist of the most pointed critique of share repurchases.
Here is the reality of this situation, from Goldman’s analysis:
Contrary to popular belief, the 247 companies in the S&P 500 with incentive compensation programs linked to earnings per share – a metric that would benefit from accretive share buybacks – actually spent a smaller share (28%) of their total cash outlays on repurchasing stock compared with the 253 firms without a performance metric linked to EPS (32%). Moreover, the 49% of S&P 500 firms with EPS-linked compensation accounted for just 44% of total 2018 buybacks ($360 billion).
Oh, and as far as whether share repurchases are crowding out investment for growth, Kostin writes that while buybacks “soared by 52% in 2018, capex grew by 14% and R&D by 11%.” That is the briskest pace of capex growth since 2011 and the swiftest pace of R&D growth in a dozen years.
You can make of all this what you will and if you’re so inclined, you can spend hours trying to poke holes in the analysis. But the bottom line is that there are quite a few “misperceptions” floating around out there and if you’re the type who likes videos, here’s Kostin’s CNBC appearance where he discusses those misperceptions: