Investors appear to be getting wise to the buyback illusion, looking not just at shares being extinguished but at the greater number being created.
By any measure, the buyback binge pursued by US companies has been huge, with S&P 500 companies buying back US$553.5bn in the year to June, up 3.8% from the year before. Overall, almost US$700bn was bought back in 2014 by US-held companies, according to Research Affiliates data.
Just looking at the S&P 500, the buybacks equate to 2.9% of the index’s market capitalization.
Yet while the combination of buybacks and dividends is often referred to as “total shareholder return” that’s actually a misnomer, just it would be if you called your purchase of an asset with borrowed money an increase in wealth.
Research Affiliates did a detailed study comparing the amount of stock US companies issued during the same period they were also rebuying shares. This task is not made easy by companies, and requires not just a close read of cashflows but also comparisons derived from stock price movements and market capitalization data.
The result: those companies which bought back almost US$700bn in 2014 issued US$1.2trn worth of stock and took on just about US$700bn of debt while doing so.
The truth: while a goodly amount of the stock issuance goes to mergers and acquisitions, much also goes to fund shares issued to pay insiders.
“When management redeems stock options, new shares are issued to them, diluting other shareholders. A buyback is then announced that roughly matches the size of the option redemption. This facilitates management’s resale of the new stock they were issued in the option redemption. Buyback? Not really! Management compensation? Yes,” write Chris Brightman, Vitali Kalesnik and Mark Clements of Research Affiliates, an asset allocation and smart beta product firm.
“Because the stock options a company issues its management dilute the value of its stockholders’ shares, companies often repurchase their stock to offset this dilutive effect. The net impact is a transfer to management of more of a company’s cash flow than is reported as compensation on the income statement. Irrespective of the intent of the company to reduce the dilutive impact of its options-based stock issuance with buybacks, the reality is that the dilution is not always totally offset.”
Getting wise
The upshot of all of this is that while share buybacks get much press, and often produce a bump in share prices when announced, investors in the US equity market suffered a net dilution of 1.8% in 2014, or US$454bn. This net dilution, according to Research Affiliates, is about par for the course over the past 80 years, implying that the recent buyback binge is not having a new shareholder, friendly effect.
There is evidence that investors are waking up to these facts.
Drug firm Johnson & Johnson announced a US$10bn buyback plan on Tuesday, just before it released earnings that beat street expectations. To be sure, J&J also said that a strong dollar was hampering earnings, but the reaction has been underwhelming, with its stock now trading more than 1 percent below where it was before the news.
Wal-Mart on Wednesday tried to sweeten a bitter pill, breaking news not just that it expects profits to fall 6% to 12% in its next fiscal year but also that it would pursue US$20bn of buybacks over two years. Not only did its stock fall 9.5 percent but Sterne Agee CRT analyst Charles Grom told clients the buyback implies contracting margins and slow sales growth.
So now buybacks are a telltale sign of weakness, rather than in some way being an element of shareholder returns.
BofA Merrill Lynch, in its monthly Global Fund Manager Survey, has for a long time asked investors what they would like to see companies do with cash flow: return it to shareholders via buybacks and dividends; increase capital spending; or shore up their balance sheets. The percentage of those who want to see cash returned is low and falling, standing now at about 20% compared to a post-recession peak in 2010 of near 40%.
What managers want instead: a rising number of them favor improved balance sheets.
The spell it seems, has been broken and investors are looking closely not at the hand that is holding and waving a shiny object, but at the one companies are keeping behind their backs.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
