Stock buybacks have played a role in the rise of U.S. financial markets since the economic downturn in 2008/2009. The impact of that role, whether a potential risk or positive catalyst, is a debate which continues within the investment community. Some investors believe buybacks are a significant driver of the rise in markets in recent years and pose a risk to future corporate profits and revenue growth and may even lead to another significant downturn in financial markets. Other investors see buybacks as effective deployment of capital which reduces outstanding shares of corporations, and thereby contributes higher earnings per share allowing for higher market valuations.
Leading global financial publications have increasingly published articles which take a more negative view related to stock buybacks. The Economist has called the recent share buyback phenomenon “an addiction to corporate cocaine”(1), while Reuters has labeled it “self-cannibalization.(2)” Other leading financial publications such as the Financial Times have called it “an overwhelming conflict of interest.(3)” Professor William Lazonick won the HBR McKinsey Award for best article in 2014 calling stock buybacks “in effect, stock price manipulation.(4)” However, in contrast to these views, there are several studies which suggest that management teams who were effective in their timing of stock buybacks, were able to deliver meaningful buyback ROI. The debate will continue as Wall Street sees buyback as a means to maximize shareholder value, while others are concerned that when the buyback music stops the potential for another financial crisis could be on the horizon.
Since changes in regulations by the SEC, regarding companies’ ability to buyback their own shares, which was previously restricted before 1982, the amount of money companies spend on buybacks has grown to 50% of corporate profits in 2017 compared with 2% in 1981(5). According to recent data compiled by Birinyi Associates and Goldman Sachs Global Investment Research, announced stock buyback authorizations as of August 2, 2018 were estimated to exceed $1 trillion dollars during 2018. This figure represents roughly a 50% increase from the prior two years, and exceeds the total economies of countries such as Mexico ($1.1 trillion), Indonesia ($900 billion), Netherlands ($800 billion), Turkey ($700 billion), Switzerland ($700 billion), and Saudi Arabia ($600 billion), per data from the World Bank(6).
Given the current S&P 500 market capitalization of roughly $23.8 trillion, the estimate for authorized buybacks in 2018 would be equivalent to buying about 5% of the index’s valuation. When combined with the reduction in daily trading volumes within the U.S., which hit a three-year low in 2017, and were down 11% year-over-year(7), we believe the sheer magnitude of authorized buybacks in 2018 should continue to support higher index levels through the remainder of the year.
We believe that stock buybacks have played a role in not only reduction of share count, and thus potentially higher earnings per share, but also have had a direct impact on the lower volatility environment, as companies are effectively a buyer of last resort or through buybacks have put a “floor” in their shares. In recent years market volatility has been extremely limited compared to historical norms. During 2017, the CBOE Volatility Index recorded 47 of its 56 lowest historical closing levels(7). To put the significance of this into context, the CBOE Volatility Index was created 24 years ago in 1993, which implies that in 2017 alone, the CBOE Volatility index saw more than 83% of its closing lows following 24 years of data. Companies have often utilized buyback announcements as a method to support shares following downturns related to missteps in execution or in lower than expected near-term operating results. We believe this has limited significant pullbacks in financial markets over recent years. During 2017, the S&P 500 index did not experience a decline of more than 3% for the entire trading year, which is unprecedented when compared with historical trends in financial markets.
Buyback Return On Investment: Not All Buybacks Are Equal
According to the April 2018 report from Fortuna Advisors, titled “2018 Buyback ROI Report”(8), over the last five years, total buybacks and dividends equaled $4 trillion, or 106% of S&P 500 companies’ net income. For the 5-year period through December 2017 the report also noted that the 353 ranked companies delivered median Buyback return on investment (ROI) of 13.8%, up from 11.2% the prior year. However, this was the first up-tick after three years of decline in Buyback ROI from the peak of 20.8%, realized over the 5 years ending in 2013.
But, according to Fortuna Advisors analysis, not all buybacks have delivered significant ROI. As an example, in their report, Fortuna Advisors notes that those companies who spent a high amount on share buybacks (24% of buyback/market capitalization) achieved lower median buyback ROI and buyback effectiveness than those companies who spent less on buybacks, as a percentage of the company’s market capitalization.
Stock buybacks have unquestionably been a buoy to stock prices, and in some cases, the earnings power of companies, when done effectively. However, Fortuna Advisors noted that the companies who derived a higher percentage of earnings growth due to buybacks and not results from operations, tended to see a decline in the price-to-earnings multiple that investors assigned. Over the last full five years, only six companies generated positive EPS growth despite declining net income, which was down from 14 in the year prior. Fortuna Advisors noted that the companies whom they described as “manufacturing EPS” demonstrated weaker share performance.
In their report, Fortuna Advisors noted that a key factor in achieving successful buyback ROI is the timing of when management enacts authorized buybacks. Tactical repurchases were often associated with higher buyback ROI, as future increases in the company’s share price have a significant positive contribution in the overall calculation. But given that many executives believe their stock is always generally “cheap” and could rise in future periods, a rules-based process for evaluating buyback timing is the most prudent strategy for delivering a high ROI.
Recent reports from the Wall Street Journal(9) suggest roughly 57% of the more than 350 in the S&P 500 companies that bought back shares this year are trailing the index’s 3.2% increase. Noted in reporting from the Wall Street Journal, the S&P 500 Buyback index, which tracks the share performance of the 100 biggest stock repurchasers, has gained just 1.3% this year; underperforming the S&P 500 index. Thus, according to recent data not all buybacks are equal, and investors should be more focused on what ROI management is achieving when buybacks are enacted.
Buybacks May Be Robbing Peter to Pay Paul
There is significant data suggesting that companies utilizing stock buybacks, as a means of capital deployment, has negatively impacted spending on long-term growth opportunities that have often been driven by increasing levels of research and development (R&D) spending and capital expenditures (CAPEX). According to data from Credit Suisse, since 1980, capital expenditures have grown a paltry 0.9% through 2015, with R&D expenditures seeing only a 4.2% increase. In contrast, spending on stock buybacks has grown 11.0%. Data from Goldman Sachs suggests that spending on CAPEX has seen continued declines since 2015, with companies estimated to spend only 27% of their cash on CAPEX in 2018, the lowest figure since at least 1990, suggesting that investment in future growth continues to decline, in lieu of use of capital allocated to stock buybacks and dividends.
Given the reduction of spending on future growth initiatives, such as R&D and CAPEX, we believe stock buybacks have become more critical to further stock market gains beyond 2018. There is limited historical data, if any, for investors to review regarding guidelines as to when the music may stop on the stock buyback dance. The last prior high for authorizations and executed buybacks occurred in 2007, the year before the economic downturn of 2008/2009. However, we can’t say definitively that stock buybacks played a major role in the market declines during 2008/2009 given the economic issues which occurred within the banking and housing markets. Thus, the significant declines in stock buybacks that occurred in 2008/2009, may have been merely a symptom, and not the root cause. However, “black swan” events, or pending economic crisis, is never telegraphed before occurring, and a significant pullback in the markets could be exacerbated, in our opinion, if management teams felt less compelled to allocate capital to buybacks during a falling market. With reduced trading volumes, which has resulted in buybacks representing a larger portion of daily market trading, coupled with the upfront benefit from recent corporate tax policy, and the fact that corporations remain the buyers of last resort in their own stocks, we believe much more caution may be warranted in 2019 and beyond, regarding the risk declining buybacks could have on future stock market increases.
Do Buybacks Really Suggest Management Believes Their Shares are Undervalued?
Recently the Securities and Exchange Commission (SEC) has begun to look more closely at share buybacks, and a unique correlation to insider selling. Per a recent speech by SEC Commissioner Robert Jackson titled ““Stock Buybacks and Corporate Cashouts” on June 11, 2018(10), there seems to be a unique correlation of insider selling following announcements of companies authorizing share buybacks. The chart below, which was included in the data appendix of Commissioner Jackson’s speech transcript, shows that insiders from 385 companies total roughly $100,000 in daily sales transaction value in the days prior to the repurchase, and total roughly $500,000 in daily sales transaction value on the day of and the eight days following the repurchase announcement—a 5-fold increase. This data suggests that the common executive defense of share buybacks, “my stock is undervalued” may not be management’s actual view if they are willing to sell shares within eight days of announcing a share repurchase plan.
We applaud the SEC for beginning to scrutinize buybacks more closely and realizing that after 36 years since the agency eased restrictions for companies to utilize stock buybacks, additional regulation may be required.
Executive Sale Lock-Up, or Israel Economic Model, May Offer Alternative
In our view, a lock-up window may be the most effective mechanism for executives enacting buybacks. In our opinion, this may be an effective method for management to validate their espoused beliefs that their shares may in fact be undervalued. Under our proposed view, upon enacting any share repurchases all Named Executive Officers (NEO) would be restricted for a period of at least 18 months from any share sales. We believe this would require executives to put into action their belief that current share valuation is in fact undervalued. This would also likely restrict the plurality of executives, whose tenure is typically only one to five years, according to a Harvard Law study(11), from selling shares during a large portion of their leadership, potentially discouraging recent concerns of “short-termism” or perhaps share buybacks altogether. Such a restriction would likely dramatically reduce the amount of enacted share buybacks. The company would no longer be able to utilize buybacks as a “floor” in shares while executives sell shares. And given the timeframe of lock-up, the ROI of share buybacks may not seem as valuable as investing in the longer-term prosperity of the organization.
As a comparison, in recent years, Israel has emerged as a leading geographic region for developing new and innovative technologies. Part of this may be the training Israelis receive during time at universities or during mandatory military service. However, after working for two leading Israeli networking companies, I believe one key reason is the government’s willingness to support R&D spending using tax credits. However, these tax credits also come with restrictions. In certain designated economic regions within Israel, companies can benefit from R&D tax credits, which help support the cost of development of new products. However, these tax-free dollars which are provided by the government to encourage increased reinvestment in the economy and further technological development, are not allowed to be distributed to shareholders. Thus, companies utilizing these R&D tax credits are not allowed to buyback shares or issue dividends from funds received to offset investment costs. It is our belief that this policy has allowed Israel to become a leading region for development of cutting edge technologies, with companies willing to continue to invest in new products or additional product lines, through use of these government tax offsets. This model could also be an effective mechanism for controlling, what in our view, is excessive stock buybacks, being utilized by U.S. listed corporations.
The potential impact from recently enacted U.S. Corporate tax cuts may have seen significantly higher overall economic contribution if companies were required to reinvest savings, like the Israeli economic model, versus the majority who have allocated these savings to buybacks and dividends. To be fair, in our assessment of how corporations have utilized savings from the recent changes in tax laws, there has been a 21% increase in corporate spending on real estate, factories, and equipment during the first quarter of 2018 per recent data provided by the New York Times and S&P Dow Jones Indices. But even with the increased spending levels during the first quarter of 2018, the majority of tax savings have been allocated to dividends and stock buybacks, which, as of today, there is no real data to determine what the impact to economic growth these actions have specifically added to the overall U.S. GDP in 2018.
Given the size of authorized buybacks announced in 2018, and the significant increase in allocation of corporate profits to buybacks since the SEC eased regulations in 1982, we believe greater scrutiny is needed to ensure that companies continue to derive shareholder value through investing in mechanisms for long-term growth, and not utilize stock buybacks as an expedited method to enhance shareholder returns over a shorter timeframe. Given the plurality of S&P 500 CEOs are only in leadership positions from one to five years, it seems buybacks have become a tool to enhance shareholder value, i.e. stock prices, during a shortened timeframe. There seems to be a lack of incentive for management teams to invest in long-term growth initiatives as executives may be near retirement, or already have exited the company, before these initiatives take hold.
Where Will Growth Come from When the Buyback Music Stops?
While we believe share buybacks provide a potential short-term “Golden Egg” scenario for markets in 2018, and potentially into portions of 2019, we have become increasingly concerned with potential for negative repercussions from a future decline in stock buyback activity, coupled with limited investments for longer-term growth. The levels of daily trading volume now equaled from share buybacks suggests that trading activity from other investors may not offset any meaningful decline in future buyback activity. Similar to the potential catalyst for slowdown in corporate buyback activity, such as a “black swan” or unforeseen economic crisis, we wouldn’t expect institutional or retail investors to “step up” in terms of trading activity if markets were to see a more pronounced downturn. Thus, we believe that in the short-term, stock buybacks will likely continue to provide a “high” to investment markets, helping to support stocks during any pullbacks and fuel higher market levels over the coming months. However, in relation to future buyback authorizations, which inevitably are betting on higher and higher stock values in future periods, corporations may want to heed the advice of Frank Lopez in the classic film “Scarface” who reminded us that a key rule is that you “don’t get high on your own supply.”
1. “Share Buybacks: Corporate Cocaine” The Economist, September 13, 2014, https://www.economist.com/leaders/2014/09/13/corporate-cocaine
2. Brettell, Karen, Gaffen, David, and Rohde David, “As Stock Buybacks Reach Historic Levels, Signs That Corporate America Is Undermining Itself”, Reuters, November, 16, 2015, https://www.reuters.com/investigates/special-report/usa-buybacks-cannibalized/
3. Plender, John, “Blowing the Whistle on Buybacks and Value Destruction”, Financial Times, February, 29, 2016, https://www.ft.com/content/0b71ca32-df0b-11e5-b67f-a61732c1d025
4. Lazonick, William, “Profits Without Prosperity”, Harvard Business Review, September 2014 Issue, https://hbr.org/2014/09/profits-without-prosperity
5. Denning, Steve, “Why It’s Raining Share Buybacks on Wall Street”, Forbes, March 25, 2018, https://www.forbes.com/sites/stevedenning/2018/03/25/why-its-raining-share-buybacks-on-wall-street/#27a1c76c3346
6. Desjardins, Jeff, “The $74 Trillion Global Economy in One Chart”, Visual Capitalist, February, 22, 2017, http://www.visualcapitalist.com/74-trillion-global-economy-one-chart/
7. Vlastelica, Ryan, “U.S. Stock Trading Volumes Hit a Three-Year Low in 2017 Amid Near-Absent Volatility”, MarketWatch, December 22, 2017, https://www.marketwatch.com/story/us-stock-trading-volume-hit-a-three-year-low-in-2017-amid-near-absent-volatility-2017-12-21
8. “2018 Fortuna Buyback ROI Report”, Fortuna Advisors, LLC, April 12, 2018, https://fortunedotcom.files.wordpress.com/2018/04/2018-fortuna-buyback-roi-report.pdf
9. Wursthorn, Michael, “Stock Buybacks Are Booming, but Share Prices Aren’t Budging”, The Wall Street Journal, July 8, 2018, https://www.wsj.com/articles/stock-buybacks-are-booming-but-share-prices-arent-budging-1531054801
10. Jackson, Robert, “Data Appendix to “Stock Buybacks and Corporate Cashouts”, Speech by Commissioner Robert Jackson at the Center for American Progress, June 11, 2018, https://www.sec.gov/files/speech-jackson-061118-data-appendix.pdf
11. Marcec, Dan, Equilar, Inc., “CEO Tenure Rates”, Harvard Law School Forum on Corporate Governance and Financial Regulation, February 12, 2018, https://corpgov.law.harvard.edu/2018/02/12/ceo-tenure-rates/