Stock Buybacks Exposed: Record Year, Outlook and Examples; Lower Growth=Lower P/E?

by the Curmudgeon with Victor Sperandeo

Record Year for Buybacks in 2018:

Fueled by corporate tax cuts from the Tax Cuts & Jobs Act (Dec. 22, 2017), U.S. companies bought back their shares at a record pace in 2018. According to data from S&P Dow Jones Indices, stock buybacks by companies in the S&P 500 index climbed to $720.4 billion in the 12 months ended in September 2018, with about $203 billion in Q3 2018 alone. For the first nine months of 2018, buybacks are up 53% to $583.4 billion, which is 1% below the previous full-year record of 2007.

While end of the year figures have yet to be finalized, S&P’s Howard Silverblatt says it was a record year. Investment research firm TrimTabs says U.S. companies spent $1 trillion on buybacks. Michael Schoonover, portfolio manager of the Catalyst Buyback Strategy fund, told Barron’s that 2019 buyback announcements were at $1.08 trillion. That number is greater than the gross domestic product of 166 countries!

Schoonover said that nearly half concentrated in 19 companies, which account for $460 billion of the total. Despite the record-setting buyback authorization levels, 2018 has been an unusual year in that fewer companies are accounting for the total buyback dollars spent.

The Curmudgeon has written extensively about how stock buybacks artificially boost stock prices by reducing the number of outstanding shares which artificially boosts increasing Earnings Per Share (EPS) and also puts more cash in stockholders’ pockets to be used for other stock purchases. In other words, the supply of stock shrinks but the potential demand increases. Please refer to this early post and this later one.

“Corporations have been a large, incremental buyer (of their own stock). That’s had a very large impact on equity market returns over the last few years,” said Wasif Latif, head of global multi-asset investing at USAA Asset Management. “It seems like that large upward pressure is going to continue to be there.”

”Companies have used their tax savings to push up discretionary buybacks and boost earnings per share through significantly reduced share counts,” said Silverblatt.

That can be easily seen in this chart, courtesy of Slate:

Who’s Getting Rich from Buybacks?

Jesse M. Fried and Charles C.Y. Wang wrote in the July 6, 2018 WSJ (on-line subscription required):

The real problem is that buybacks, unlike dividends, can be used to systematically transfer value from shareholders to executives. Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses. Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity. Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity. Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.

Executives can use repurchases to enrich themselves because disclosure requirements are woefully inadequate. When executives trade personally, they must publicly disclose the details of each trade within two business days. The spotlight created by such real-time, fine-grained disclosure helps curb trading abuses by executives. By contrast, the SEC only requires a firm to report, in each quarterly filing, the number of shares repurchased in each month of the quarter and the average price paid per share. Investors see this filing a month or so into the next quarter, one to four months after the buybacks occur. And they never see individual repurchases, just aggregate transaction data. Researchers can detect the existence of buyback abuses across a large sample of public firms, but investors cannot easily identify the particular executive teams using repurchases to line their own pockets.

As Victor notes in his comments below, not all buybacks work to keep the stock price high. Former DJI AAA rated General Electric (GE) is a great example. Former CEO Jeff Immelt spent $21 billion in 2016 buying back GE shares at an average price of $30.30. Currently, GE shares are trading around $8 per share on the NYSE - about 75% off its $33 high set in July 2016.

A surprise loser of recent buybacks was Apple. Apple lost about $9 billion in 2018 as a result of buying its own stock, according to the WSJ (again, please refer to Victor’s comments below). That loss was increased on January 3, 2018 when Apple's slashed earnings outlook took the iPhone maker's stock down 10%.

Democratic Senators Chuck Schumer of New York and Tammy Baldwin of Wisconsin have introduced legislation to “rein in” corporate stock buybacks. The bill would give the Securities and Exchange Commission authority to reject buybacks that, in its judgment, hurt workers. It also would require boards to “certify” that a repurchase is in the “best long-term financial interest of the company.” Sen. Baldwin has introduced another bill, co-sponsored by Sen. Elizabeth Warren (D., Mass.), that goes even further: It bans all open-market repurchases.

Outlook for Buybacks in 2019:

Silverblatt estimates that the dollar amount of stock buybacks will be similar to 2018 or ~ $1 trillion. As long as the tax structure remains the same and the economy doesn't fall apart, he expects companies will have the cash flow to fund the buybacks.

Schoonover says 2019 is poised to be another strong year for buybacks, especially if some of the market headwinds subside.

Goldman Sachs forecast $940 billion worth of buybacks for 2019, while JPMorgan looks for ~20% fewer dollars spent on buybacks this year. The investment and commercial bank recently estimated $800 billion worth of buybacks will take place in 2019.

Joseph P. Quinlan, head of market strategy at Bank of America, said last year's record share repurchases are likely to be a one-time event. Instead, he sees lower stock buybacks as a result of decreased repatriation cash flows. "As the cost of capital continues to rise," he said, "firms will probably resort to more holding of cash/capital (in 2019) vs. doling it back to shareholders via buybacks and dividends."

Instead of investing in future growth by increasing capital expenditures, companies have been buying back their own stock and increasing dividends. However, Economist Robert Soloff worries that the decline in investment, especially since the 2008 financial crisis, has taken on a new urgency. He wrote in the book What Would the Great Economists Do?: “…the stimulation of investment will favor intermediate run growth through its effect on the transfer of technology from the laboratory to the factory.”

Victor’s Comments and Provocative Opinion:

In the not too distant past, when a company bought back its stock, it meant the company was going private. Yet the original purpose of Wall Street was to help companies go public in order to raise capital by selling shares to the public. Investment bankers also manage secondary offerings, where companies sold additional shares to expand operations through increased capital investment. Raising capital (risk money) to create businesses for the profit motive is the essence of capitalism. The company’s business and their intended use of the capital obtained by selling shares to the public are detailed in the IPO (Initial Public Offering) Memorandum and Prospectus, which are mandated by law and overseen by the SEC. Generically, these are referred to as “Disclosure Documents.”

With these basic principals in mind, if a company is buying back stock, they don’t need any such documents or permission from the SEC. However, I think a disclosure document should be provided to shareholders in this case. Why? Because the purpose the stock was sold to the public was to raise capital to grow the company by building real products or providing services.

In recent years, buying back stock (with QE created “free money,” zero/very low interest rates, borrowed money, corporate tax cuts, or profits) is an effort to NOT to grow the company! Instead, it is an accounting trick to boost the PRICE of the stock by reducing the float, which artificially increases Earnings Per Share (EPS). Such manipulation enables the company insiders, officers, and board of directors to sell their stock and/or stock options at a higher price.

If a company is buying back stock what are the risks to the investors? As an example, let’s briefly analyze Sears. The company spent a reported $6.2 billion buying 21.7 million shares of stock, and then eventually went bankrupt. Evidently, the purpose of the buyback was to hold up the stock price, not to increase profits. Sadly, Sears plans to hold an auction on Monday January 14^th for the company's assets. The company has already closed hundreds of stores in recent years, including dozens in recent weeks. Ask yourself if that was not immoral or (in my view) illegal?

The purpose of the company changed, because the fundamentals of store/mall shopping changed consumer preferences. That was largely due to the rise of on-line shopping and retail innovations like Amazon.com. I firmly believe Sears shareholders should have been fully notified that the company had no ideas on how to create profits, much less grow the company. Moreover, the officers did not want to return the $6.2 billion (spent buying back shares) to the stock holders, as the fat cat majority owners would not make any money on such a deal.

It seems ironic that when a company sells stock, rules and regulations require the company fully disclose risks, but if a company uses the capital or profits for a NEW AND DIFFERENT purpose the SEC does not require a disclosure of that along with the new risks?

There were an estimated $1 trillion in stock buy backs in 2018. Since all stock indexes were down for the year, perhaps 99% of all those buybacks are losers. Apple was one such casualty of stock buybacks at high prices. The 12/28/2018 WSJ (on line subscription required) reported that Apple stock buybacks lost the company more than $9 billion! Apple spent most of 2018 ravenously buying back its own stock on the open market, fueled by a large corporate tax cut windfall. Through the first nine months of 2018, Apple spent $62.9 billion on share buybacks, a record-breaking and staggering sum that happens to be exactly equal to Apple's revenue in the quarter that ended in September. Apple and companies like Wells Fargo, Citigroup Inc. and Applied Materials, etc. re-purchased their own shares at high prices, only to see their value decline sharply. In effect, the stock market has told them they overpaid by billions of dollars.

Obviously, reducing the shares outstanding increases earnings per share, all things being equal (which increases the bottom line). But revenues will be lower, or flat most of the time (which lowers the top line). As such, the logical deduction for investors of a company buying back shares should be to reduce the P/E!

Most investors don’t get this as they (like the insiders) believe buying back stock increases the stock price. But the reason for investing in stocks is to earn profits at a growing continuous rate. That is the basis for the P/E! If a company grows its earnings it is worth more and can and thereby increase dividends without increasing the coverage ratio. To purchase the stock of a company that is buying back its own shares without a declining P/E is irrational in my opinion, as the future of the company is shrinking, not growing.

Also, the accounting of earnings before, and after, buybacks should be stated or taken into account. Obviously money spent on buybacks cannot be used to pay dividends. This puts insiders and shareholders at odds, or in a conflicted position. Those who have stock “options” don’t get dividends, so these officers only care about stock price appreciation. This is another conflict which is not obvious. How important?

End Quote:

To quote an American forensic accounting scholar and Professor of accounting:

“Accounting (measuring financial data with a depreciating currency) is much like looking at a bikini on a beautiful girl. What it reveals is interesting, but what it conceals is vital.” -Abraham J. Briloff.

Good luck and till next time………………….

The Curmudgeon
ajwdct@gmail.com

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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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