The Elephant In The Room: Share Repurchases

by David Robertson

In a famous Indian parable [here] a group of blind men encounter an elephant. Since each blind man encounters a different part of the elephant (e.g., the tusk, the leg), there is a great deal of disagreement as to what the elephant is. The moral of the story is that “humans have a tendency to project their partial experiences as the whole truth.”

Projecting partial experiences as the whole truth has become standard practice in the arena of investing. Explanations for continued strength in stock prices range from strong economic growth to contained inflation to lower taxes to technology. It all depends on the partial experiences of the observer. There is, however, a different and yet dominant influence on stock prices that rarely gets the attention it deserves. That proverbial “elephant in the room” is share repurchases.

Of course no-one is claiming that economic factors are not critical determinants of share values — there is no disputing that. Actual prices, however, are determined by markets and as such, represent a form of competition between buyers and sellers. When buyers compete more aggressively, prices go up, and when sellers dominate the prices go down. In short, stock prices, like so many economic goods, are determined by supply and demand.

Based on this relationship and on recent positive price action, it is easy to infer that the bulls are winning. Further, it is tempting to associate this positive result with strong economic growth (at least in the US), low unemployment, low inflation, and lower corporate taxes. All of this feeds an alluring narrative: Finally, things are getting back to normal.

But the bears are not unworthy competitors. As John Authers reports in the Financial Times [here], trends in the expected return assumptions used by pension plans are a good indicator of sentiment towards the markets. Here the evidence is decidedly pessimistic: “Every single year of this young millennium, assumed pension returns have fallen — from 9.2 per cent in 2000 down to 6.5 per cent a year.” He adds that, “AQR publishes regular forecasts for five- to 10-year returns, and predicts real returns of 4 per cent on US equities and 4.7 per cent on emerging markets. Other assets would be weaker.” Other credible estimates are even lower.

As a result, there seems to be something of a paradox. Despite what seems to be a fairly evenly matched competition between bulls and bears, the market has continued to rise since its decline in February. Why would market prices keep going up even when it seems like supply and demand are pretty evenly matched?

The answer is partly illuminated by an old economics lesson. Markets do a pretty good job of determining prices based on the important assumption that there is a fairly diverse group of buyers and sellers and that each acts in its own economic self-interest. In real life, however, this is not always the case. In a prior blog post [here], for example, I pointed out that central banks have been buying significant quantities of stocks for purposes of public policy rather than as an effort to realize attractive financial returns.

While central banks have certainly distorted stock prices with their purchases, their impact pales in comparison to that of companies repurchasing their own shares. The scale has been mind boggling. As the FT notes [here],

“Between 2012 and 2015, US companies acquired $1.7tn of their own stock, according to Goldman Sachs.”

Calcbench also conducted a survey of common stock repurchases over 25 quarters of data through Q1 2018 [here] and calculated over $3 trillion was spent over that time.

By way of comparison, the $3 trillion amount comprises a significant 10% of the $30 trillion current value of the entire US stock market. Further, assuming repurchase trends continue through 2018, the FT reports [here],

“That would lift the total since 2010 to over $5tn, bigger than the Fed’s entire $4tn quantitative easing programme.”

Share repurchasing is not just notable for its massive scale, but also for its increasing trend. The FT reports [here],

“The almost $437bn in buyback plans announced in the three months to June 30 eclipsed the previous quarterly record of $242bn, which was set just three months earlier, according to TrimTabs, an investment research company.”

The FT also reports [here] that the latest annual estimate by Goldman Sachs is for “a record $1tn in share buybacks this year.”

As a result, share repurchases are doing a lot more than just “tipping the scales” of supply and demand. David Kostin, chief US equities strategist for Goldman Sachs summarized it best:

“[share] repurchases remain the largest source of demand for shares.”

Indeed, Bank of America observed [here],

“in the first half [of 2018], corporations were the only net buyers of stocks.”

Repeat: “the only net buyers of stocks.”

This highlights a startling characteristic of today’s market: It’s not even remotely a balanced competition between buyers and sellers. Kostin also observed that:

“most other ownership categories [households, mutual funds, pension funds] are net sellers of stocks.”

Bank of America reported that “institutions and hedge funds have been net sellers throughout 2018.” Harley Bassman summarized [here],

“In fact, away from Corporations purchasing equities (buy-backs or mergers), it is unclear who else is supporting the stock market against the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into bonds.”

One might expect corporations to be more judicious in their share repurchase activity, but that is not what the evidence suggests. Zerohedge reports [here],

“Corporations are not particularly price sensitive — buybacks tend to rise with the market”.

In addition, a report by Andrew Lapthorne of Societe Generale summarized in the FT [here] reached a similar conclusion:

“the correlation between a stock’s quality and its propensity to buy back stock is negative, and has been for most of the time since a brief period post-crisis.” In fact, he goes on to say, “Buybacks can be a ‘tell’ of a poorly run company, not just a company with few good growth opportunities.”

While the sheer volume of share repurchases has affected markets, its seasonal nature has had an impact as well. As noted [here]:

“August tends to be the most popular month for companies to execute their share repurchases, with the month accounting for 13 per cent of annual activity.”

Given typically low summer volumes, August share repurchases also increase the chances of producing a disproportionately beneficial impact on share prices.

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In addition, seasonality of share repurchases also comes in another form. They tend to decline during the “blackout periods” before and immediately after companies report earnings. Chris Cole states bluntly on RealvisionTV [here]:

“I don’t think it’s any coincidence that the worst drawdowns in equity markets — we’re talking about the period in 2015 or January 2016 or this recent February drawdown — I don’t think it’s a coincidence that they’ve occurred during the five week share buyback blackout.”

Cole is not alone in this assessment; the same conclusion is also reached [here] and [here].

Another interesting feature of the share repurchase trend has been the degree to which it has been financed by debt. It so happens that the total amount of increase in corporate debt has almost perfectly coincided with the amount of share repurchases. This fact was highlighted by Zerohedge [here]:

“And as we first pointed out over two years ago, all net debt issuance in the 21st century has been used to pay for stock buybacks…”

An excellent example was provided by Horizon Kinetics [here] in their analysis of how

“The McDonald’s share price appreciated by 90% over 7 years.”

The explanation features two main components:

“One thing that happened is that McDonald’s P/E ratio expanded from 16.9x to 24.6x. That share-holders were willing to pay more for the same earnings accounted for about half of the stock return. Another thing that happened was that interest rates dropped; for 10-year Treasuries, from 4.08% at the beginning of 2008 to 2.30% at year-end 2015 (and to 1.77% now [Q1 2016]). This permitted McDonald’s to finance a massive share repurchase program that would have been unaffordable but for these artificially low rates, which is why its interest expense only rose by 22% even as its debt ballooned by over 6x this amount.”

Viewing market activity through the “lens” of share repurchase activity not only creates some extremely important implications for investors but also provides some clear prescriptions as well. For starters, since share purchase activity is dominated by price insensitive share repurchases, stock prices reveal little information content about underlying economics. This helps explain why neither inflation fears nor trade wars nor emerging market chaos nor increasing rates have been able to rein in stock prices to any great degree. This also explains how a great deal of pessimism about stocks can co-exist with rising prices and bullish narratives.

Another consequence of large scale share repurchase activity is that it has facilitated excessively high stock valuations. This creates a dangerous trap for investors. While high valuations may appear, superficially, to validate underlying economic strength, they are really just temporarily masking the darker reality of “the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into bonds.” In other words, despite appearances, there is likely to be a big drop in stocks in the not-too-distance future. After all, if conditions were really so good, why would market participants such as “institutions and hedge funds” be net sellers?

An important consequence of a market of artificially inflated prices is that it creates winners and losers by effectively transferring wealth. Artificially inflated prices today mean lower returns tomorrow. That is good for investors who want to sell today and bad for those who need to realize future returns in order to achieve investment goals.

One key group of beneficiaries includes retirees (and others) who have been rebalancing their portfolios away from stocks. They are benefiting from a remarkable coincidence of artificially inflated stock prices at exactly the same time they want to de-risk their portfolios. As luck would have it, there could hardly be a better time to cash out.

Of course corporate executives are also benefiting in the form of higher (share-based) compensation and an attractive opportunity to dispose of their share holdings. Zerohedge reported,

“there’s a dirty little secret lying just beneath the surface of this ‘different this time’ ramp in stocks. Insiders are dumping their shares to retail investors at an almost unprecedented manner…”

Grants Interest Rate Observer also reports in its June 15, 2018 edition that some repurchase announcements appear as if they are designed to create “cover” for insider selling:

“U.S. Securities and Exchange Commissioner Robert Jackson complained that management teams are using buybacks to pad their own income. According to number-crunching by SEC staff, insiders increase the amount of stock they sell by five times in the eight days following a share repurchase announcement.”

Unfortunately, just about everyone else loses. Artificially inflated prices force everyone with a longer investment horizon to make very difficult decisions on an ongoing basis. It forces people to determine whether factors such as large scale share repurchases will persist long enough to provide an attractive exit within the time frame of their investment horizons. Wait too long to sell and you face a big drawdown that could take a long time to recover from. Sell too soon and you aren’t earning the returns you need to meet retirement goals.

Younger investors are hurt because low expected returns on stocks discourages them from doing one of the best things they can do for themselves — start saving early. While such people still have plenty of time to save for retirement, every year prices are inflated and future returns are suppressed is one less year they have to reach their goals.

Perhaps the greatest risk is to investors who are nearing retirement or are recently retired and still have significant exposure to stocks. These investors run the risk of not selling stocks before prices drop down to more sustainable valuations. The risk here is of suffering a significant drawdown at exactly the wrong time. Such an event could either substantially defer retirement or redefine it altogether.

Because the consequences of diminished share repurchase activity are so severe, it behooves investors to monitor conditions that could cause such a change. The biggest factor is arguably the ability of companies to continue funding share repurchases at such high levels. With unemployment near record lows and profit margins near record highs [here], cash flows are more likely to get worse than better. It would be dangerous to extrapolate such favorable conditions very far into the future.

Harley Bassman also points out some debt-related factors to watch:

“So clearly higher rates driven by the FED could reduce buybacks funded by debt.”

Bassman also suggests that any twists in tax policy could also have a negative effect:

“if tax reform were to include a provision to reduce the tax advantage of corporate borrowing, that would raise the effective cost of debt, and may be the catalyst for reducing share buy-backs.” Bassman also hypothesizes, “or if the companies themselves reach up against a level where they may face downgrades or limits to their debt loads.”

The FT also reported a recent warning by BCA [here]:

“Dwindling balance sheet flexibility will become a serious constraint underscoring that the tailwind from buybacks is ending and could [change] into a headwind next year if cash flow does not recover.”

In addition to keeping an eye on what could cause share repurchases to decline, it also makes sense to keep an eye on when. Remembering that share repurchase activity is seasonal and tends to decline during blackout periods, late September, just before most third quarter earnings come out, will be a good time to observe what happens to stock prices when the impact of share repurchases is diminished.

In conclusion, most investors catch only glimpses of what happens in the markets if they catch anything at all. As result, much like the blind men and the elephant, it is easy to experience only partial truths rather than the greater whole. The challenge for investors is made even greater because self-interested market commentators don’t even need to lie in order to deceive; they can simply distract with agreeable narratives. Resist the tendency to extrapolate partial truths. Manage to your investment horizon. And focus on the things that count most by keeping your eyes on the “elephant in the room”. Right now that is share repurchases.


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