Three weeks ago, in a series of posts, we reluctantly took up the buyback debate again.
“Reluctantly” because at this juncture, the issue has become hopelessly politicized on one side (the anti-buyback push on Capitol Hill) and on the other side, it’s impossible to disentangle selfish rationalizing from honest efforts to clear the “good” name of share repurchases. Here’s how we put it back on March 13:
- 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.
That’s from a pretty lengthy post which contained some excerpts from an expansive note by Goldman’s David Kostin, who endeavored to dispel what he called “popular misperceptions”.
Kostin’s arguments were convincing as far as this discussion goes, but invariably, critics will always point to self-interest when it comes to anything Wall Street has to say about buybacks, just as Wall Street will generally allude to political capital when it comes to dismissing some lawmakers’ demonization of share repurchases as a rather transparent effort to score political points at a time when any narrative about wealth inequality plays well with voters.
Most recently, Bernie Sanders and Chuck Schumer took aim with a plan to limit share repurchases, and that just adds to existing pressure from the likes of Elizabeth Warren and (especially) Tammy Baldwin who, you’re reminded, is angling to simply get rid of buybacks.
Well, on Friday evening, Goldman’s Kostin linked to Baldwin’s bill (introduced last year and co-sponsored by Warren) and imagined a world without buybacks.
“Eliminating buybacks would immediately force firms to shift corporate cash spending priorities, impact stock market fundamentals, and alter the supply/demand balance for shares”, Kostin writes, stating the obvious, before reviewing what Goldman thinks would be the five major implications of a buyback prohibition.
First is slowing EPS growth. This is self-evident and really doesn’t need to be explained, but Goldman reminds you that “aggregate earnings growth trails EPS growth because buybacks boost earnings per share by reducing the number of shares outstanding [and] during the past 15 years, the gap between EPS growth and earnings growth for the median S&P 500 company averaged 260 bp (11% vs. 8%). In 2018, the spread equaled 200 bp (20% vs. 18%).”
Second, Kostin delves into how corporate management would shift their cash spending and, unfortunately for those who continue to insist that curbing buybacks by decree would automatically equal more capex and R&D spending, Goldman says that probably wouldn’t be the case.
“Most managements would probably redirect cash that was previously spent on buybacks towards dividends (both regular and special) and funding more M&A”, Kostin says, before delivering an assessment that, again, won’t line up well with the increasingly shrill protestations of those who swear that buybacks are a pernicious beast that serves to depress investment by incentivizing myopia. To wit:
- During the past decade, capex and R&D have accounted for an average of 45% of S&P 500 annual cash spending which has consistently equaled about 8% of sales. Investment spending has always been the first priority for corporations. If attractive projects had existed in previous years, those initiatives would have been funded. Simply put, without new investment opportunities firms are unlikely to suddenly spend more than 8% of sales on capex and R&D.
“Funny” probably isn’t the right word here and regular readers are well aware of our liberal-leaning tendencies, but with those two caveats aside, there sure would be something funny about Democrats bending over backwards to eliminate buybacks only to see management teams ramp up dividends and M&A and embark on formal tender offers for shares.
The really interesting part (and this is point three) comes when Kostin suggests that prohibiting buybacks would, quote, “lead to a greater amplitude of index moves, a wider distribution of individual stock returns, and higher volatility.”
You can be sure critics will write that off as fearmongering, but on the other hand, how many times over the past year have you heard someone say that buybacks served as literal “plunge protection” during 2018’s various bouts of volatility, or that things could have been worse in the absence of the corporate bid effectively putting a floor under things? I’d wager you heard it on quite a few occasions, especially if you frequented these pages.
Recall, for instance, how trading activity on Goldman’s corporate desk spiked during the Vol-pocalypse. Here’s the chart from February 2018 for anyone who needs a reminder.
Kostin goes into the numbers as follows:
- During the past 25 years, the 20th percentile return for stocks within the S&P 500 has averaged -27% (annualized) in buyback blackout periods compared with -16% when companies can freely repurchase their shares. The average (11% vs. 5%) and 80th percentile (61% vs. 40%) stock returns are also higher during buyback blackouts likely due to the boost from quarterly earnings releases. Return dispersion (16 pp vs. 14 pp) and volatility (16.4 vs. 15.8) during blackout windows have also been higher compared with non-blackout periods.
In the same vein, it’s entirely possible to argue that buybacks serve as a kind of circuit breaker for the liquidity-volatility-flows feedback loop which played havoc across equities on at least three occasions last year. That is, in the absence of buybacks, that self-feeding loop could be even more efficient (in a bad way) than it already is during routs.
Fourth, Goldman reminds you that buybacks are the largest source of demand for US equities – and it’s not even close. We’ve parroted that line over and over and over again, but it’s imperative that folks realize just how startling the numbers really are. “Since 2010, corporate demand for shares has far exceeded demand from all other investor categories combined”, Kostin reminds you, on the way to noting that “net buybacks for all US equities averaged $420 billion annually during the past nine years [while] during this period, average annual equity demand from households, mutual funds, pension funds, and foreign investors was less than $10 billion for each category – despite the fact these categories collectively own 83% of corporate equities.”
Finally, history shows that a 250bp drop in forward EPS growth is consistent with a 1-point de-rating (i.e., multiple contraction), which means that if EPS is no longer inflated by share repurchases, you can expect the market to add insult to injury by paying less for every dollar of earnings.
So, I suppose the question is: “Is this really what everybody wants?” If corporate management teams will just find a way around any effort to stymie shareholder returns and if capex and R&D spending aren’t likely to rise as a result, what’s the point?
Perhaps it’s better to avoid legislative outcomes that turbocharge share repurchases (e.g., the Trump tax package) than it is to try and dictate how corporate America should spend its cash after the fact.