By: Steve Smith
Earlier this week, we discussed how artificially low interest rates were helping to suppress volatility which in turn was elevating valuations. Today’s investing advice will look at another form of potential market distortion – buybacks.
Common criticism of buybacks cites these reasons:
- It’s a poor allocation of capital that could and should be better spent on building the business through spending on research, equipment or strategic acquisitions.
- It reduces share count thereby artificially increased the price-to earnings multiple, the denominator in P/E earnings per share shrinks.
On the surface, this practice may seem like nothing more than some unproductive, sleight of hand accounting where no one gets hurt. But buybacks actually do have a significant downside; the repurchased stock is dead and the cash is in the hands of the seller. Where once there was a liquid stock and cash, there is now just cash. So, half the previously existing economic value has been eliminated, and the outstanding share count has gone down.
If the company has extra cash, it should returned to shareholders in the form of dividends. Or heaven forbid, raise workers wages, which ultimately can make the company more productive and profitable.
By some calculations, U.S. firms have spent roughly $4 trillion on buybacks from 2009 through 2012, making corporations the biggest single source of demand for U.S. shares.
And the pace isn’t slowing down. In fact, it’s accelerating. 2017 saw $720 billion in buybacks, and 2018 has already registered $171 billion, putting it on pace to cross $1 trillion for the year.
According to Artemis Capital, buybacks have accounted for 40% of the total earnings-per-share growth since 2009, and an astounding 72% of the earnings growth since 2012.
Buybacks have been essential fuel for the low-volatility regime, enabling steady equity appreciation and in turn, the rules-based strategies pegged to that tranquility. Now, as volatility returns to equity markets, buybacks will likely prove key to understanding and anticipating the threat of a high-volatility crash. That’s why we’ve focused on this phenomenon for today’s investing advice.
In Artemis’ report Alchemy of Risk, they make the connection between buybacks and the suppression of volatility, noting that “not surprisingly, the recent “VIX tantrum” corresponded to the tail end of the buyback blackout period. The SEC forbids buybacks during quarterly reporting to control insider trading.”
Since 2009, the largest equity drawdowns — August 2015, January to February 2016, and two weeks ago — all occurred in or right after the share buyback blackout period. Even less surprising, corporations stepped in after February 5, 2018, bought the dip, and suppressed volatility.
What could bring a change to relentless bid that buybacks supply? Once again, it would be seemed tied to interest rates. The cheap money, in which some companies actually issue debt to buy back shares has provided cover for this financial gamesmanship. The longer the “valuation illusion” is sustained, the more costly it will prove when rising interest rates force reality. In this environment, the best investing advice is to tread cautiously; the market can only defy gravity for so long before coming back to Earth.