Comstock Partners, Inc.March 31, 2016
Corporate Buybacks Aren't What They Used To Be
“Financial 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.
In this 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’ comparison.
While we 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.
There are several arguments made by buyback opponents that go as follows:
These 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.
In summary, 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.