"Sluggish activity will spur firms to repurchase shares in an effort to boost EPS growth"
- Goldman Sachs
Back in April 2012, we predicted [9]that the Fed's "visible hand hand is forcing corporate cash mismanagement", stating explicitly that the Fed's ZIRP and QE, "is now bleeding not only the middle class dry, but is forcing companies to reallocate cash in ways that benefit corporate shareholders at the present, at the expense of investing prudently for growth 2 or 3 years down the road."
It is now three years later, and according to the latest Factset snapshot [10], revenue growth in Q3 is set to decline 3.7% from a year ago a quarter where corporate earnings are poised for their first recession since 2009. As we predicted, companies not only did not invest sufficiently in capex, R&D and other forms of organic, and thus revenue growth, but instead unleashed the biggest shareholder-friendly tsunami in history, with record buybacks, M&A, and dividends in the years following.
Sure enough, as can be seen in the chart below, after spending 55% of total cash proceeds on organic growth in 2009 (capex and R&D), since then shareholder-friendly strategies have taken over again, and Goldman now expects that organic growth will account for only 40% of total cash spend, with Buybacks, Dividends and Cash Acquisitions accounting for 60% of total use of cash proceeds.
[11]
Furthermore, according to the latest forecast by Goldman's David Kostin, this surge in buybacks will continue for the simple reason that with Capex spending set for its first decline since 2009 (mostly due to the commodity crunch forcing countless energy companies to put capital expansion on indefinite hiatus), investors will have nothing else to reward, so may as well forego even more future revenue growth and demand an immediate cash out right here, right now.
[12]
From Goldman:
Managements will remain committed to returning cash S&P 500 firms will return more than $1 trillion to shareholders in 2016 with buybacks and dividends each growing by 7%. We expect high cash return strategies to outperform given modest GDP growth, low rates, and slim equity returns. A similar macro environment in 2015 rewarded stocks with high cash returns to shareholders while firms investing in capex lagged.
[13]
Ah, the efficient "market": rewarding companies that instead of investing in the future, and growth, promptly cash out and engage in a slow-motion (ideally debt-funded) LBO. For those confused why sales are down 3.7% in Q3 and set to tumble in the years ago, there is your answer.
Goldman continues:
Share repurchases will exceed $600 billion (+7%) in a low growth, low return market. Our economists expect modest US GDP growth of 2.4% in 2016. Sluggish activity will spur firms to repurchase shares in an effort to boost EPS growth. We expect S&P 500 will deliver a 3% total return in 2016.
Here is Goldman confirming what we predicted would happen all the way back in April 2012:
During the recent zero interest rate regime, investors rewarded firms returning cash to shareholders via dividends and buybacks over those investing for growth via capex and R&D. The effects of a slow recovery in aggregate demand suggested that the returns from investing in physical assets (capex) were unlikely to generate outsized profits. With few productive capex opportunities, many firms prioritized returning cash to shareholders and these stocks outperformed.
And that's why revenues are sliding, earnings are now officially in a recession, and millions more layoffs are coming regardless of the BLS' endless data fabrication as companies do everything in their power to keep margins as high as possible to offset the topline contraction.
And while Goldman admits that during periods of rising yields, the stocks of companies that invest in CapEx and R&D outperform the "buybackers", it also says that this time it's different.
However, we expect stocks with high total cash returns will outperform in 2016 despite the bear flattening yield curve environment. Although the Fed will be tightening, interest rates will remain low on a historical basis. The muted pace of economic expansion in the US, the uncertain prospects for global growth, and a low expected S&P 500 return, will leave investors searching for yield.
So buy stocks the buy their own stock. Got it. Only.... any time Goldman tells its client to do something, the opposite usually happens. Could that be the case again?
Most certainly, and here is one explanation for the recent market revulsion with prolific repurchasers (see IBM, KORS [14], CAT [15]). It comes from Citi which shows that contrary to conventional, and wrong, wisdom, gross corporate leverage has never actually been higher. Throw in rising rates, and blowing out spreads, and suddenly all these companies that enjoyed a free ZIRP lunch by engaging in the dumbest of capital allocation decisions, namely pushing their own stock higher (by issuing debt no less), are about to vomit it all right back.
Corporate leverage continues to push higher. In Figure 3 we present the debt-to- EBITDA ratio for the average non-fin in the IG and HY markets. We see that in IG leverage rose from 1.8x to 2.1x over the past twelve months, and in HY it rose from 4x to 4.4x (Figure 3). Note that in both markets, at current levels gross leverage for our sample set is well north of the ‘09 highs. Unfortunately, we see little chance that it will decline in the near-term, or even stabilize for that matter, as the earnings backdrop appears to be too soft.
[16]
The 3-fold increase in share buybacks in the past five years has been the key driver of corporate re-leveraging. In large part, buybacks have been the result of strong incentives provided to corporate managers by activists in particular and equity investors in general. As Citi’s Equity Strategists highlighted in March, companies that spent more on shareholder handouts and less on investments have tended to get higher price/earnings ratios in the market.
But not for much longer, because if the Fed does indeed launch a tightening cycle, it means game over for the one trade that has worked the best in the past 3-4 years. Which also explains why Goldman is now aggressively pushing clients to buy companies that are the most notorious "Total Cash Returners" - because Goldman's prop desk has a lot of these to sell, as Citi also admits: "In sum, we feel strongly that the pace of buybacks will ebb."
