Engineering” as it applies to a corporate structure usually is defined as the
aggressive use of various techniques to enhance shareholder value by affecting
the balance sheet. Probably none has
received more attention over the last several years as stock buybacks. It seems that not a day goes by that CNBC and
the financial media are reporting that companies have initiated or increased
share buyback authorizations, and there has been a great deal of attention
given over the last many months to whether share repurchases represent a
judicious use of a corporation’s capital.
report we will attempt to shed some light on this topic and also examine what
message the market may be saying about large companies that are doing
buybacks. This is possibly one of the
most important questions facing market participants today since the U.S. has
been in a zero or near zero interest rate environment for 87 months (an
unprecedented amount of time.) During
that time corporations have raised record amounts of long term debt at
historically attractive levels, while at the same time remaining voracious
buyers of their own shares. The major buyback companies as a whole have
outperformed over the last 7 years, since the bottom on 3/9/09. However, this recently has not been the case
as we will illustrate.
Now in this
era where it seems there is an index for any financial asset class that can be
measured there are indexes of companies that are buying back their own
shares. The performance metrics of the
two most popular are reasonably similar so we will focus on just one, the
S&P 500 Buyback Total Return Index (SPBUYUT). This index is calculated by S&P back to
1994 (numbers sourced from Bloomberg), though it appears a more recent creation
since trading volumes and ranges don’t appear until 2013. This index is equal dollar weighted and
rebalanced quarterly. It is a subset of
the S&P 500 consisting of the 100 companies that for the 4 previous
quarters have repurchased the largest percentage of their market capitalizations. We will compare this to the S&P 500 Total
Return Index (SPXT). This index is
capitalization weighted and like SPBUYUT reinvests dividends. It is thus a reasonable “apples to apples’
would argue that returns on financial assets have been inflated by an
experimental and dangerous environment the Fed has created through QE and ZIRP
the numbers tell us that since the market low on 3/9/09, SPXT has returned 252%
while SPBUYUT has returned 374%. A
shorter and more recent time frame, however, tells a somewhat different
story. Since the 3/9/09 market low there
are 29 rolling 4 quarter periods we examined.
Of the 29 periods, there have been five where SPBUYUT
underperformed. There were 2 in 2012 and
the most recent 3 (through this writing on 3/29/16). The largest of the 5 is the last 4 quarter
roll and the underperformance number is 7.02%.
So we believe that the market is starting to punish companies that are the
most voracious buyers of their own stock.
several arguments made by buyback opponents that go as follows:
Buybacks steal from the future by
expending resources that should be used to fund/ensure future growth in
exchange for the short term gratification of a higher stock price that is the
result of the buyback. Worse yet, if
financed with debt, the debt has to be serviced and paid back eventually.
Buybacks do not return money to all
shareholders (as dividends do) but rather only to selling shareholders; (that
are now no longer shareholders)
Corporate managements have an
inherent conflict of interest when, as is typically the case, their
compensation is determined by EPS metrics that are influenced by the buybacks
arguments make sense to many, including us.
It is likely true, however, that when the markets are near the high end
of their all time ranges, most investors either don’t care or overlook these
facts. When the extended bear market
that we see coming arrives in earnest, we believe the finger pointing and
recriminations will arrive with it.
our regular readers know that we believe the U.S. is in a long term
deflationary cycle that is the result of excessive debt (see attached “Cycle of
Deflation”). The debt situation has been
exacerbated for the last 87 months by the “experiment” of QE and ZIRP by the
Fed. Other Central Banks have followed
with their own QE and ZIRP/NIRP. During
this time frame corporations have been large buyers of their own stock with
much of it financed by debt. This most
certainly has been a prop under the market.
But as stated above corporations are doing so to the detriment of long
term investment in the business. While
in the past, indexes of companies doing buybacks have outperformed their market
benchmarks, that has started to change recently. Buybacks done at elevated levels of valuation
will prove to be ill conceived and ill timed (think Devon Energy and Amerada
Hess which recently needed to sell equity at levels far below stock repurchase
levels of the past several years).
Companies doing excessive buybacks will negatively affect future growth
by underinvesting in capital assets; all the worse if financed with debt. Because
of the aforementioned facts and circumstances, yesterday’s stock buyback
winners could prove to be tomorrow’s losers.
We believe that will be the case.