One key factor to the 2017 outlook for equity returns that we rarely discuss is corporate buybacks. Although the large majority of individual investors do not follow corporate buybacks on a regular basis, they are a great way to take the pulse of the U.S. economy.
What are corporate buybacks? Corporate buybacks occur when corporations take cash off of their balance sheet or borrow money to purchase outstanding shares of their stock. By purchasing shares of their outstanding stock, corporations reduce the number of shares outstanding to the public. This strategy allows companies increase their earnings per share (EPS) without actually increasing their earnings. The tactic has become more popular in recent years as the cost of debt has remained cheap and the economy has lacked rewarding alternatives to draw the attention of corporations looking to invest capital. To demonstrate how important corporate buybacks have become, since 2012 it is estimated that 25% of all corporate earnings growth can be attributed directly to corporate buybacks.
How? The problem with corporate buybacks is that it’s a low-quality source of earnings growth. It has nothing to do with demand for a company’s product or services. It’s the simplest form of financial engineering. For example, in the world of mathematics, if the numerator remains unchanged and the denominator is reduced….VOILA! The answer is larger! In the below example, XYZ Company experiences a 14% increase in earnings per share growth simply by repurchasing 250 shares of outstanding stock, but nothing actually changed.
EXAMPLE: XYZ Company repurchases 250 outstanding shares
$1,000,000 Earnings / 2,000 outstanding shares = $500.00 Earnings per share
$1,000,000 Earnings / 1,750 outstanding shares = $571.42 Earnings per share
To be clear, there are circumstances where buybacks are in the best interest of shareholders. However, the reason that the economy dislikes buybacks is because it comes at the expense of innovation, research and development. Meaning that corporations are sacrificing long-term investments into the economy for short term earnings per share growth to please investors.
Why are corporate buybacks in the spotlight now? S&P 500 share buybacks amounted to $115.6 billion in the third quarter (Aug-Oct), which represented a 28% decrease year-over-year and the smallest quarterly total since Q1 2013. It matters for several reasons. First, it means that buybacks are slowing down. The S&P 500 hit five record highs in December. This has pushed the Forward P/E ratio to 17.1, which represents a 13.5% and 18.8% premium to the five-year and ten-year average P/E multiples. As valuations increase higher and higher, companies have to pay more to repurchase their shares. This slowdown is a sign that corporate management teams are starting to feel that buying back their stock at premiums may not be the best use of their money. Secondly, the Federal Reserve’s 25bps December interest rate hike should cause further slowdown to buybacks. With many companies issuing debt to fund their buybacks, rising interest rates will make the cost of repurchases more expensive. Finally, the slowdown in buybacks will affect earnings. In Q3, the earnings growth rate of the S&P 500 was 3.1%, which marked the first time the index has seen year-over-year growth in earnings since Q1 2015. A significant portion of this growth was the result of corporate buybacks. Analysts are estimating that 2017 earnings will finally grow at levels (+11%) necessary to justify the equity markets rally. However, if buybacks have truly hit a wall, and it looks as though they may have, we can expect earnings expectations will take a hit as well. As always, we will continue to monitor.
Reid Davis serves as a Wealth Strategist and Chairman of the Investment Committee at Pinnacle Trust. You can reach Reid by emailing him at email@example.com or by calling the office at 601-957-0323.