One of the themes we’ve been keen to advance this year is the idea that the rally in US equities is in large part attributable to corporate buybacks. In essence, companies tap yield-starved investors in the debt market and use the proceeds to repurchase shares, thus ensuring a constant bid for their stock while artificially inflating earnings and propping up the value of equity-linked compensation at the same time. All of this comes at the expense of capex (i.e. investing in future productivity and growth) and as we’ve noted on several occasions, is easy to spot if one looks at the divergence in the percentage of companies beating earnings estimates versus the percentage of companies beating revenue estimates.
Over the weekend, we pointed to data from JPM which shows that equity withdrawal in the US (IPOs minus buybacks/LBOs) is the most negative it’s been since early 2008 and has trended lower in lockstep with the long-running rally in US stocks, suggesting yet again that in this case, correlation may indeed imply causation.
Here’s more from Morgan Stanley on the buyback binge, its relationship to the equity rally, and what it all means for corporate health:
Why Are Companies Buying Back Shares? Lack of confidence in organic growth alternatives, very low cost of debt relative to equity, a struggle to improve ROEs, and relatively flat WACC curves have driven the pace of share buybacks. While buybacks are more conservative than capex or LBOs (both of which are well below last cycle’s peaks), they erode credit quality by draining cash and/or increasing debt, and we expect them to continue.
The Credit Lens: Buybacks improve “per share” metrics the most, while levering the capital structure. At 2.2x, gross leverage for IG companies is now higher than at the peak of the last cycle. As such, it is important for credit investors to focus on broader fundamental metrics while taking stock rallies with a grain of salt. Indeed, we find that CDS begins to widen 30 days post buybacks, even as the stock price continues to rally. Overall stocks with high buyback ratios have outperformed by 10% since 2013.
As we penned our outlook for US investment grade credit in 2015, one of our top “worries” heading into the year was the rising trend in shareholder friendly activity and more specifically the surge in stock buybacks. In 2014, the constituents of the S&P 500 on a net basis bought back ~$430Bn worth of common stock and spent a further ~$375Bn on dividend payouts. The total capital returned to shareholders was only slightly less than the annual earnings reported. On the fixed income front, the investment grade corporate bond market saw a record $577Bn of net issuance in 2014. While the equity and bond universes don’t overlap 100%, we think these numbers convey a simple yet important story. US corporations have essentially been issuing record levels of debt and using a significant chunk of their earnings and cash reserves to buy back record levels of common stock…
As we noted in a recent report, corporate balance sheets are no longer as pristine as they were in the immediate aftermath of the financial crisis (see Exhibit 2). Gross leverage for the median US IG company (~2.2x) is higher than it was in the 2006-2008 period and is now approaching the highs seen in 2001
Corporations have limited avenues to grow earnings in the long run, given a tepid and long recovery. Since 2012, more than 50% of EPS growth in the S&P 500 has been driven by buybacks and growth ex-buybacks has been a mere 3.3% annualized. Unlike previous cycles, share repurchases could be the primary avenue of re-leveraging in the current cycle in the absence of high growth and financial leverage. In a low-growth, low-return world, the strong trend in buybacks could continue as companies lack alternatives to reward shareholders. Further, as history shows us, companies tend to buy back more stock as the price increases and in a downturn, a sharp sell-off in stock prices will effectively lead to an erosion of the equity cushion.
And in case the above isn’t clear enough, here’s a graphic showing the relationship between equity performance and buybacks…
...and here’s a bit more color…
Looking back at the equity performance of companies that had the highest buyback ratios, we find that this basket has outperformed the broader market by ~73% since the beginning of 2004 (5% annualized). In the current cycle, share buybacks have been on an upswing; since 2013 the outperformance of buyback-heavy stocks has been even starker, at 10% on an annualized basis.
...and as we've pointed out on dozens of occasions, all of this all comes at the expense of capex…
Apart from buybacks, other measures of corporate spending/leverage portray a more benign picture. For example, capital expenditure levels in the 1990s were materially higher over a sustained period of time. Average YoY growth from during this period was roughly 15%. Similarly, after the recession of 2002, CAPEX rebounded strongly and was in double-digit territory over the next 5 years. In the current cycle, CAPEX growth has been tepid at best and with the exception of 2011, has struggled to match the last 2 cycles.
Meanwhile, as WSJ reports, investors are chasing the buyback-fueled rally by doing exactly what corporate America is doing: employing leverage.
Borrowing is rising in the stock market as well. In March, stock-market margin debt hit $476.4 billion, the highest level in records going back more than 50 years, according to the New York Stock Exchange.
Rising margin debt “suggests people expect the rally to continue,” said Ana Avramovic, trading strategist at Credit Suisse.
She said margin debt outstanding tends over time to track stock-market index levels. The Nasdaq Composite Index last month hit its first record close since March 2000. The S&P 500 has hit six all-time closing highs this year and the Dow Jones Industrial Average four, and the two U.S. stock gauges have together hit 198 record closes since 2013.
Summing up: record corporate issuance, record buybacks, record stocks, and record margin debt. So when the cycle finally turns and everyone who gorged themselves on corporate debt in a desperate attempt to find yield suddenly discovers just how illiquid the secondary market has become (prompting fire sales) and when the margin calls start for everyone who has borrowed in a frantic attempt to serve as the greater fool for the last guy who bought on margin, don't say we didn't warn you.