Recently, corporate share buybacks have become a target of scrutiny by a few politicians. There is even isolated talk of a proposal linking a ban on buybacks unless a company is paying at least $15 an hour, giving employees seven days of paid sick leave, a pension and healthcare. Another proposal would seek to place a tax on share buybacks in order to drive more domestic capital investment. Putting aside the political rhetoric, let’s take a look at how share buybacks are used today and what their true impact is on the market.
Not all buybacks are created equal. Companies often buy back shares to boost earnings as, typically, earnings-per-share figures go up as the number of shares goes down. Buybacks can be made after a company has done analysis concluding that their stock is undervalued. Companies also frequently repurchase shares to offset the dilutive effect of employee stock options or restricted shares awarded to incentivize and align their staff as long-term shareholders. In addition, they are sometimes made late in the economic cycle when there are fewer attractive alternatives for spending cash. Buybacks are often viewed as investments in lieu of capital spending or dividends, but are usually made at times when cash flow is high and all options can be considered. Occasionally, repurchases are made to the detriment of the company, where debt is taken on for the repurchases only to see a subsequent and significant drop in the share price.
Recent tax reform has been a driver of share buybacks by permitting companies to repatriate foreign earnings back at a more attractive tax rate, which has provided an influx of capital for buybacks. The previous American Jobs Creation Act of 2004 specifically discouraged the use of repatriated cash for buybacks, while no similar restrictions exist now. In general, post the 2008-2009 financial crisis and subsequent quantitative easing era, there has been a sharp rise in the amount of stock repurchases, with low interest rates being a significant contributing factor. The S&P 500 index divisor is at a 20-year low, reflecting a reduction in equity supply. However, mergers and acquisitions are also a reason for decreased supply.
There may be a perception that share buybacks have made a large contribution to total return. However, a research study by Morgan Stanley, published 19 February 2019, shows that with cumulative total return of the S&P 500 of 124% between 2011-2018, net income growth led the increase with 73% contribution, dividends 25%, forward P/E multiple expansion 14%, while share buybacks were 12% of the return.
S&P 500: Contributions to Total Return (124%), Jan. 2011-2018
Furthermore, buybacks as a theme through the current cycle have contributed approximately 2% to annual EPS growth as S&P 500 companies have returned about $5 trillion to shareholders via repurchases, as shown below from a 25 January 2019 research publication by J.P. Morgan.
Buybacks A Key Theme of the Cycle
Despite higher shareholder payouts, S&P 500 companies have demonstrated their commitment to growth via investment with double digit increases in capital spending and R&D. In fact, S&P 500 capital expenditure, “CapEx,” had the fourth largest increase on record in 2018, suggesting that investing for the future is not being ignored as some would have you think. This is shown below from a 14 February 2019 publication by Strategas Research Partners.
Annual Change in S&P 500 CapEx $B
According to J.P. Morgan, companies that have returned capital to shareholders in the way of share buybacks and dividends tend to do better in challenged markets, outperforming their peers by 1.5% on average during corrections and by 2% during recessions looking back to 2000. In addition, these higher buyback yield stocks tend to be less volatile compared to their peers. We witnessed record buyback announcements of $938 billion in 2018 that were high quality in nature, funded predominantly by cash rather than debt. While the leverage spread, earnings yield less bond yield, remains attractive at over 200 basis points, there has been a noticeable decline in companies using debt funding of buybacks which peaked at ~34% in 2017, declining to ~14% most recently suggesting that as interest rates have ticked up, companies have begun to curtail their more opportunistic use of debt to fund repurchases. This can be seen in the next chart, also from the recent J.P. Morgan publication.
Buybacks Increasingly Cash Funded
In terms of sectors where share repurchases have been most prominent, Technology had the heaviest weight given their stronger growth, higher margins, lower capital requirements as well as higher overseas cash balances.
In summary, in our view, shareholder payout ratios, be it dividends or share buybacks, are low and sustainable. Late last cycle, companies returned 100% of profits to shareholders versus the current 75% level. Given the remaining share buyback authorizations and the high cash balances that remain overseas, as well as where we are in the current cycle, we believe that the trend for buybacks will continue and that efforts to put an end to them will be ineffective.