Companies are repurchasing their own shares at a rate not seen in nearly a decade, prompting observers to fret that demand for equities is not as strong as the past six weeks' rally would suggest.
According to FactSet, S&P 500 companies repurchased $158.2 billion worth of shares in the third quarter of 2015, the highest level since the corresponding quarter in 2007, when buybacks totaled $161.6 billion. For all of 2007, buybacks totaled $550.8 billion, a level surpassed in 2014 ($565.7 billion) and again in 2015 ($567.2 billion).
Share buybacks last peaked in 2007, shortly before the financial crisis, a correlation which has prompted characterizations of the practice as a sign of late-cycle irrational exuberance. Critics of repurchases point to the way they can alter companies' earnings picture and decrease their abilities to weather crises.
Share buybacks are a way for companies to return cash to investors, similar to dividends. They decrease the number of outstanding shares, which in principle boosts demand for the stock – and its price – by decreasing supply. The effectiveness of the practice is disputed, but leaving that aside, there are questions about whether we should revisit the record repurchases of 2007.
First of all, not every company that's buying back shares is in a position to do so, and some are taking on debt to fund repurchases. Activists often push companies with excess cash on their balance sheets to return it to shareholders. Apple Inc. (AAPL), which bought back more stock than any other S&P 500 in the last quarter of 2015, is a perfect example, with over $200 billion in cash still left on its balance sheet after $6 billion in repurchases.
Other companies, however, are borrowing to fund buybacks, weakening their financial positions and leaving them more vulnerable in the event of another crash. FactSet data shows that nearly 150 companies in the S&P 500 have trailing-twelve-month (ttm) buybacks exceeding their free cash flow, up from around 30 at a low-point in 2010. In early 2008, the level exceeded 200.
Activist investors are stepping up their efforts, which may in part explain the uptick in buybacks. They waged 70 campaigns – around 30 of which were successful – to return cash to shareholders through dividends or repurchases in 2015, according to FactSet, a third-again more than in 2014 and more than at any time since 2005, when FactSet began tracking the data. The previous peak for activist campaigning was in 2008.
According to Bloomberg, the current quarter may exceed the previous record for buybacks, with the S&P repurchasing perhaps $165 billion worth of shares. They note that this record level of demand contrasts sharply with demand from retail investors. Judging by flows into and out of mutual funds and ETFs, individuals are selling, even as companies accelerate their buying.
That begs the question: what happens if companies stop buying back shares? Goldman Sachs Chief U.S. Equity Strategist David Kostin pointed out to Bloomberg last month that companies generally pull back from repurchase programs during their pre-earnings release blackout periods, which provides a glimpse of what the market might look like with decreased corporate demand for shares. The S&P 500 did plummet 11% in the first six weeks of the year. Any number of other factors were at play, but the correlation is worth noting.
Effects on Earnings
Is it such a bad thing if corporate buybacks are stepping in to fill a gap left by anxious individual investors? Perhaps not, but buybacks have other effects, aside from the increased debt mentioned above. They can, for example, obscure companies' earnings picture by decreasing the number of outstanding shares, allowing earnings per share (EPS) to outpace net income.
In the quarter ending December 2015, Microsoft Corp. (MSFT) saw its net income decline by 15% compared to the prior-year quarter. Earnings per share, however, only declined 13%, since the company had purchased $17.8 billion worth of shares over the preceding 12 months. According to FactSet, ttm net income for S&P 500 companies has declined for the past five quarters, while buybacks have continued apace.
Buybacks can also distort compensation. A Research Affiliates report from October notes that repurchases let managers receive "more of a company’s cash flow than is reported as compensation on the income statement," since companies that give stock awards and options often keep outstanding share counts steady through buybacks, without disclosing them. In addition, the boost to EPS buybacks provide can trigger performance-based pay boosts for executives, creating perverse incentives that hardly benefit shareholders.
The Bottom Line
Share buybacks are a way of returning cash to shareholders, which in theory they should love. But individual shareholders are fleeing the market, so the fact that stocks are not slumping may be due to companies' demand for their own shares. That makes for a tenuous source of demand, which is prone to fizzle if companies run out of spare cash to fund buybacks. Many companies are already buying at levels that exceed their free cash flows, some are taking on debt, and activist investors are pushing harder than ever for companies to repurchase and boost dividends. Finally, buybacks distort earnings and compensation pictures, which can harm shareholders' interests.