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Four months into 2019, research shows that institutional investors are not pouring money into the stock market. The market is nevertheless rising relentlessly after the very weak fourth quarter of 2018, when stocks got oversold. So, the following question presents itself: who is putting money at work? We have seen that there has been a significant amount of short covering in January (investors closing an open short position by buying back borrowed securities, which they had previously sold) and that retail clients have again joined the party. However, there is another group of investors putting their money hard at work: listed companies buying back their own shares.
Why are they doing so?
The number one reason is simple: it makes the price of the stock go up. Investors often look at the Price-Earnings ratio, whereby Earnings are expressed as earnings per share. If the share count (or denominator) declines due to companies buying back shares, the earnings per share ratio goes up meaning that the Price-Earnings ratio goes down. Thus the company seemingly has gotten cheaper and can rerate to the upside again. This is positive for the shareholder in the short run but it also means that the company is not investing its cash in the real economy to support the acceleration of future growth. At the same time, it can lower the cost of capital of the firm since expensive equity financing is replaced with cheaper debt financing or excess cash.
Is it healthy?
For those companies that generate a lot of free cash flow, buying back shares might be an interesting alternative use of cash aside from other investments focused on growing the company. When faced with a dearth of good investment opportunities, it can be better for companies to return the cash to their shareholders rather than waste it on doubtful acquisitions or capital expenditures. Lately, however, there is more evidence that some companies solely focus on this short-term stimulus, thereby neglecting long-term investments. They often do so not only by using their free cash flow, but also by issuing more debt. The current low rate environment, caused by the extremely loose central bank policy, has only facilitated this behavior. The result is that some companies are effectively levering up their balance sheet (long-term financing) for short-term market gains. This is one of the factors behind the tremendous increase in US nonfinancial corporate debt amongst others:
Source: DPAM, Federal Reserve, Bloomberg
If taken too far, these companies might be more vulnerable when the next recession comes along and their credit spreads widen. After all, putting the debt at work by buying back shares does not result in an increase of their repayment capacity. Furthermore, buybacks are a procyclical phenomenon: even companies that only put in their excess free cash flow will see their ability to do buybacks constrained when the economy hits a downturn.
A couple of months ago, the US Securities & Exchange Commission (SEC) issued a research paper that described that many corporate executives sell significant amounts of their own shares after companies announce share buybacks. If these practices are proven and if they continue, regulators might step in.
Understand that buybacks were illegal throughout most of the 20th century because they were considered a form of stock market manipulation. In 1982, the SEC passed rule 10b-18 , which created a legal process for buybacks.
Some democrats who might run for the 2020 presidential election, like Elizabeth Warren, are focusing on inequality and a review of the legal process of share buybacks. A potential ban on share buybacks will certainly become a point of discussion in case the SEC’s research paper leads to court cases.
What has been the impact?
Since the great recession of 2008, companies buying their own shares have accounted for all net purchases of equities. The total amount of stock bought back by companies in the US vastly exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing.
Source: DPAM, Bloomberg
It is safe to say that the numbers are impressive and that they should not be disregarded. Share buybacks constitute a technical support for equities and may remain doing so as long as rates remain low and a recession is avoided, which is our base case scenario.
In terms of stock selection, investors should be wary of those companies that finance share buybacks with newly issued debt because they are not generating the necessary free cash flows. These practices may continue for a while but there some examples of companies that went out of business because of it. Today, there are 536 zombie companies, characterized by EBIT below the interest expense, in the OECD. Such a high number was previously only witnessed at the end of a recession but never when the economy was still growing, albeit more slowly.
Avoid being overly negative on equities even though a lot of future growth has been priced. Good stock selection is key for outperformance.