Share buybacks have become an inherent feature of the U.S. stock market over the last decade. There are several reasons for this trend.
First is why they have become popular. One of the main benefits of share buybacks is that they reduce the number of shares in issue, allowing a company to grow its earnings per share, even if profits are static.
With stagnant growth in parts of the economy and larger corporate cash piles, an increasing number of firms have chosen to spend their cash on their own stock.
U.S. company buybacks are close to all-time highs, and the U.S. corporate sector has been responsible for the shrinking number of shares in issue by almost a quarter over the last ten years. Recent data show that 3% of all demand for equities is made up by companies buying their own stock.
U.S. companies are currently returning more cash in buybacks than they do in dividends, but the two combined are now well in excess of cash flows that companies are generating. This clearly isn’t sustainable, raising concerns that this vital pillar of support to the U.S. equity market is about to be kicked away.
Share buybacks have a historic correlation with the stock market’s progress
Source: Bloomberg, Thomson Reuters Datastream, February 2016. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index. For illustrative purposes only.
There are two potential funding sources by which buybacks could be sustained. The first is by an improvement in corporate cash flow generation. In our view, this looks unlikely to happen.
U.S. corporate cash flow growth has recently stalled, and there is little improvement visible on the horizon. Weak energy, the strong dollar, lack of pricing power and sluggish demand all present challenges to companies. Moreover, we believe profits forecasts for S&P 500 companies provide little hope for an imminent change.
What would investors prefer companies to do with cash flow?*
*Vertical axis: % of respondents of the Bank of America Merrill Lynch Fund Manager Survey (see source below).
Source: Bank of America Merrill Lynch Global Fund Manager Survey, February 2016. For illustrative purposes only.
Companies could also borrow to pay for stock purchases. This potentially makes financial sense, as with yields at such low levels, it is currently very cheap for companies to continue borrowing to make share repurchases.
However, the scope for such additional financial engineering is becoming limited, as levels of debt have grown in recent years. And in these uncertain times, shareholders are starting to favor balance-sheet strength over capital return. So a fall in share buybacks appears imminent.
Given the support that buybacks have provided to the U.S. equity market, there are reasons for caution should this significant pillar of support be removed.
Share repurchases are unlikely to stop overnight, and there are reasons to see their continuation in the very near term, including the expiry of the closed period following the quarterly reporting season. There is also a lag between announcements and implementation. Sometimes, this can take up to two years.
But if the U.S. stock market is going to make further progress, it looks like companies are going to have to start generating real earnings the traditional way – by growing sales, improving efficiencies, or both.
The use of leverage will increase market exposure and magnify risk.