Last month in “Who Is Buying? [7]”, we pointed out the glaring disconnect between aggressively negative equity flows and record highs on the S&P and Nasdaq. With some corporate management teams still stuck in buyback blackout limbo, it seemed strange that equities were still being bid given that share repurchases are set to be the biggest catalyst for US stocks in 2015 (as a reminder, Goldman sees pension funds and households combining for outflows in excess of $400 billion).
As a reminder, is a look at projected net equity flows [8]…
[9]
... and here’s the peculiar chart...
[10]
Whatever the reason(s) for the disconnect (and we suggested a few interesting possibilities), investors needn’t concern themselves too much going forward because starting next week, the debt-fueled buyback bonanza can begin anew, meaning that once again, stocks will benefit from the price insensitive, corporate management bid, all brought to you by yield-starved credit investors who have been perfectly willing to snap up new issuance (which for IG hit a Q1 record this year) and look the other way as companies plow the cash back into their own shares at the expense of future productivity. Here’s Goldman:
Of the 362 companies that have now reported 1Q results, 45% of companies have beaten earnings estimates (below the historical average of 46%) and 11% have missed estimates (vs. average of 15%). Next week, these companies, which represent more than 80% of the S&P 500 market cap, will have exited their repurchase blackout period and may resume buybacks, which should provide renewed support for the market.
For those who require still more proof that the rally in US equities has become inextricably linked with corporations leveraging their balance sheets to repurchase their own shares, JPM is out with an in-depth look at buyback trends which strongly suggests — unsurprisingly —that buyback activity has indeed been very supportive of US shares over the last several years.
Via JPM:
Apple announced an expansion of its dividend and buyback scheme to return $200bn to shareholders by the end of March 2017, up from $130bn previously. This adds to the flurry of share buyback announcements this year bringing the YTD total of $315bn which in annualized terms ($945bn) is more than double last year’s $450bn (Figure 1). The doubling in announced share buybacks globally appears to be driven by US companies which are tracking a YTD pace that is 2.2 times last year’s pace. Non-US share are 1.4 times last year’s pace…
[11]
It’s not quite that simple though, because the net amount of shares drained from the market must also take into account LBOs and, on the other side of the equation, IPOs and secondaries…
First, equity withdrawal is also a function of M&A/LBO activity which adds to the equity withdrawal impact of share buybacks. It is also a function of IPO/secondary equity offering activity which instead reduces the equity withdrawal impact of share buybacks.
When looked at from the perspective of IPOs and secondaries minus buybacks and LBOs what we actually find is that net equity issuance (i.e. more shares in the market, not less) came in at around $136 billion in Q1.
However, calculating equity withdrawal/issuance in this way is problematic…
One drawback is that share buybacks are announced rather than actual. Another drawback is that share buybacks are gross rather than net, i.e. they omit the exercise of stock options and employee stock programs as well as the exchange of common stock for debentures and conversion of preferred stock or convertible securities. One way of adjusting for this to look at quarterly cash flow statements of companies which report actual (rather than announced) buybacks on both gross and net basis. These actual net share buybacks are shown in Figure 3.
[12]
JPM then strips out the European component and nets IPOs against actual net share buybacks in the US and sure enough, a familiar picture emerges.
How does the picture of net equity issuance of Figure 2 change if one uses actual net buybacks instead of announced gross share buybacks? To answer this question we use a slightly modified formula which looks at the difference between IPOs minus net actual share buybacks and LBOs. Secondary offerings are omitted from this formula because they are already incorporated in net buybacks contained in companies’ cash flow statements…
A positive share issuance outside the US has been a persistent phenomenon since the Lehman crisis. While before the Lehman crisis US and non-US companies have been both buying back their own shares, since the Lehman crisis there has been a large divergence with US companies continuing to buying back their shares and non-US companies issuing shares instead…
This is also shown in Figure 5. It depicts the net equity issuance of US companies proxied by the difference between US IPOs and actual net US buybacks and US LBOs. It confirms that net equity withdrawal has been rather healthy and steady in the US, rising roughly in line with equity prices over the past four years.
[13]
Looking at the chart above it would appear that JPM may be understating the case. Net equity issuance is the most negative (i.e. aggressive equity withdrawals) it’s been since early 2008, and it’s been trending steadily lower for the better part of six years, which of course coincides perfectly with the inexorable rally in US stocks.
As a reminder, the buyback-fueled rally comes at a cost. When corporations issue debt to repurchase shares, they're taking on interest expense (even if, thanks to the Fed, borrowing costs are low) but are not investing in the future growth they'll need to service the growing debt pile. So while record buybacks can support the rally, artificially inflate EPS, and enrich management teams in the short-run, over the long-haul, financial engineering is not a viable strategy for producing sustainable corporate growth and profitability.
