One would think that companies announcing stock buybacks when their shares are trading at or near all time highs would be a less than rational and prudent use of funds. After all, everyone knows what happened to IBM which we first profiled as a prolific repurchaser in early 2014, and which after buying back $100 billion in stock since 2007 has seen its return on buybacks implode to levels that would see any hedge fund PM fired in milliseconds.
Then there was Monsanto, which likewise repurchased billions in shares, just to lose billions in the process.
However, companies are less than "rational and prudent" when it comes to boosting the stock-linked employee compensation, which in recent years has soared, mostly thanks to unprecedented amounts of buybacks. In fact, in 2015 buybacks have already soared by 50% more than in 2015, rising to over half a trillion dollars.
This, however, may soon be ending for two key reasons.
First, here is Goldman's Charles Himmelburg with an unexpected empircial finding: the performance of serial "repurchasers" has lagged not only that of companies that return cash to investors mostly through dividends, but the market itself.
S&P 500 buyback announcements have jumped by 50% vs. last year to $521bn. Firms are also returning cash via dividends: 249 S&P 500 firms have raised their payouts YTD with a median hike of 10%.
Our equity strategy team continues to recommend being overweight their 'total cash return basket' (GSTHCASH), which they just rebalanced in the above report. This basket is sector-neutral and consists of the 50 stocks in the S&P 500 with the highest trailing 12-month total cash return yield. Exhibit 1 shows that, as of the close on October 26, 2015, this basket has outperformed the S&P 500 YTD by 85bp (3.15% vs. 2.24%).
However, the analogous basket of firms selected on the basis of high buyback yields alone (GSTHREPO) has underperformed the S&P 500 this year by 2.67% (-0.47 vs. 2.24%). This underperformance contrasts to the first quarter this year when both baskets were up comfortably over the S&P 500. The past few months, however, have seen both baskets underperform, with the 'buyback' basket underperforming by over 2.5% since early September. Could equity markets be suffering from buyback burnout? If so, it would come as welcome relief for corporate bond investors.
In other words, being your own best friend, and buying back your own stock in the hundreds of millions or billions is doing just one thing: accelerating the cash out of others, who are happy to sell stock faster than corporate CFOs can buy it.
This is troubling for a market in which the primary source of demand for shares have been, for the past 3 years, corporate buybacks.
But it gets worse: as we have shown before, the driver of the recent slowdown in buyback activity has little to do with debt investors becoming more prudent or no longer rewarding management teams who cash themselves out,(after all it's other people's money, and all that matters is generating a high-ish yield until bonus season, at which point the bond investment is someone else's problem). In other words, it has little to do with the eagerness of C-suites to sell debt just so they can buyback more stock.
The real reason for the slowdown has to do with the spread on investment grade debt, and nowhere is it seen better than in the chart below, which shows clearly that buybacks performance relative to the market is tracking the investment grade credit spread one to one. Because the higher the rate of interest, the higher the cash the company needs to generate to maintain EPS.
In other words, the decline in buyback activity is primarily a function of rising credit spreads, which will continue rising as long as the bond market is drowning in supply and as long as fears exist that the Fed may hike rates, which will push not only the underlying yields but the spreads on corporate instruments as well. This, and of course, systemic issues like the collapse in the junk bond market over the past year driven mostly by the plunge in commodity prices.
So for all those hoping that buybacks will prove to be the source of much needed stock upside, be careful, and keep a very close eye on IG credit spreads: if these continue widening, then the buyback window may just slam shut very soon.