In Barron’s Up & Down Wall Street column, titled “Buyback Bonbons,” Kopin Tan marvels that “Companies have already repurchased a staggering $445 billion worth of shares in the 12 months ended on September 30.” According to Josh Brown of the Reformed Broker blog, this is enough to buy more than half the real estate in Manhattan. Tan writes the buy-back bonanza “merely reflects the abundant cash sloshing through our markets, and the dearth of convincing, good ideas for just exactly what else to do with it.” Josh Brown opines that in a low-growth environment buy-backs “are less risky career-wise for a CEO or a board of directors than expansion or acquisitions.” Recently Pimco’s Bill Gross noted “Stocks have their own QE: ‘corp buybacks’ at $500 billion a year. They are a main reason stocks go up. When do THEY taper?” The overall impression we get is that buy-backs are an artificial and unsustainable boost to stock prices resulting from misallocation of corporate capital.
Buy-backs’ Two Functions
This buy-back hype is misleading because it does not take into account a second reason, in addition to returning capital to shareholders, why companies repurchase shares: to prevent “share count creep” from employee stock options. If companies did not buy back shares and the share count increased, earnings per share would decline. My former colleague David Bianco, Chief U.S. Equity Strategist at Deutsche Bank, wrote a great report on this topic back in November. According to him, S&P 500 companies spent 5% of market cap on net buy-backs over the past two years but shares declined only 2.3%. In effect, about half of the “$500 billion” ballyhooed by Barron’s, Brown & Gross is not a return of capital to shareholders, but employee compensation.
The mechanics, as explained by David Bianco, are as follows. In the cash flow statement the “funds spent on buy-backs” figure is a net number: expenditures on buy-backs minus money received by companies when they issued shares to employees who exercised stock options. Shares are repurchased at the market price, which is higher than the strike price at which stocks are sold to employees exercising their options. Therefore the percentage decline in shares outstanding is significantly less than (net buybacks as a percentage of market cap). Here’s a simple example. Assume XYZ Corp. has 100 shares outstanding, with a market price of $10, implying a market cap of $1000. If XYZ buys back 20 shares at the market price of $10 each ($200 total) and sells 10 shares to employees for $5 each ($50 total), then:
- Its net expenditure on buy-backs is ($200 minus $50) or $150, which is 15% of market cap.
- Its shares outstanding decline by (20 repurchased minus 10 issued) or 10, which is only 10% of shares outstanding.
A Modest Boost to EPS Growth
The reduction in the S&P 500 aggregate share count from buy-backs boosts S&P 500 EPS by shrinking the index divisor, which is declining 1-2% annually. This is not trivial, but with index EPS rising 6-9% in 2013 and 2014 share buy-backs definitely are not the main driver of earnings growth. The reality is that firms’ allocation of cash is currently quite rational and shareholder friendly. Firms are not afraid to invest for growth where opportunities exist, but capex is disciplined—unlike the behavior of tech and telecom firms in the late 1990s or of big banks during the housing bubble. Judicious investment preserves profit margins by preventing over-capacity. Meanwhile, firms are raising dividends rapidly and buying enough shares to boost overall EPS modestly—which is a lot better than the share count creep which usually occurred in the past. M&A activity has also been disciplined.
Why Timing Is “Terrible”
One other point. It is often said that companies have “terrible timing” when they buy back stock, because they buy more at the top of the market than during recessions. My first response is: Join the club! – most people are terrible market timers, so why should companies be any different? Aside from that, companies need to repurchase more shares when the stock market is strong, the price of their own stock price is rising, and more employee stock options are “in the money.” Also, it is better to buy back stock near the top of the market than to make dumb acquisitions. By the way, during the next recession all the strategists who now criticize corporations’ market timing will be churning out lists of “safe” companies with strong balance sheets, giant cash hoards, and minimal debt—not the ones that are buying back lots of stock.
True Yield
In measuring how much capital a company is returning to shareholders, one should not look at money spent on buy-backs, but rather at the actual shrinkage in share count. “True Yield” – a measure of the total amount of capital returned to share holders – equals (dividend yield + annual percentage decline in shares outstanding).
A profitable, well-managed, mature growth stock should be able to grow EPS 6-12% (through a combination of organic growth, acquisitions, and share buy-backs that reduce the share count 1-3% annually) and also offer a dividend yield of 2-3%. That implies a total return of around 8-12%, which is not bad when 10-year Treasuries yield 3%. A few companies shrink their share counts far more aggressively; Eddie Lampert’s Autozone comes to mind.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
