DataTreks Colas on Stock Buybacks

In a recent newsletter, Nicolas Colas, co-founder of DataTrek Research revisited the topic of corporate buybacks. Traders Magazine is republishing his article with permission.

Stock buyback activity in US equity markets is simply staggering at present: $646 billion for the 12 months ending June 2018 for the companies of the S&P 500. Total dividend payments arent far behind, at $436 billion. The bright spot: the total of the two is $1,082 billion, only 90% of 12 month trailing operating earnings of $1,197 billion. Thats a better buffer than existed in 2015/2016, and an underappreciated positive for US stocks.

You cant restate a dividend, Wheels…

That statement requires two quick explanations. First, my hedge fund nickname was Wheels because I covered the auto industry. And, because on my first day of work at SAC Capital I drove up in a bright yellow Porsche 911. Stevie made some vocal inquiries on this point in front of the room. He wasnt a fan. The nickname stuck, however, even when I found a more appropriate ride.

As for the fundamental observation, that came much later when I worked for an immensely talented private value-oriented investor. He was a fan of big payouts. To him, they proved out the cash generation ability of a company better than anything else. Today we swim in his intellectual wake to address a basic question about US equity prices.

There is, at present, a legitimate concern that we are at the top of a US corporate earnings cycle. Tax cuts have goosed net margins, as has strong economic growth. How much longer can this last? One observation on that count:

FactSet currently shows that Wall Street analysts have 5% revenue/10% earnings growth penciled in for 2019.

Those neat round numbers are analyst-speak for Were totally guessing here.

Anything from trade/tariffs to economic slowing will see those estimates revised quickly downward.

Also, as we noted yesterday there is no fresh investor money flowing into US stocks in 2018; the marginal buyers are companies themselves as they repurchase stock. On top of that, dividend yields – the S&P 500 pays 1.7% – are well below 1-year Treasury payouts at 2.58% today. If (or really, when) US corporate earnings decline, buybacks will be slashed first and dividends will shortly follow. It has always been thus, after all.

To assess just how much risk US corporates face on their buyback/dividend outlays, we pulled the historical data from Standard & Poors. We did this math earlier in the year for you, but it is time for a refresh given strong first half earnings results and outsized Q3 stock rally.

Heres what the numbers show:

#1. Unlike 2015/2016, the companies of the S&P 500 are no longer spending 100% or more of their operating profits on buybacks-plus-dividends. In those years, the ratios were 108% and 102%, respectively. For the 12 months ending June 2018, dividends-plus-buybacks were 90% of operating earnings.

#2. The dividend payout ratio (dividends divided by operating earnings) for the S&P 500 is down to 36% for the 12 months ending June 2018, lower than 2015/2016 (both 43%) or 2017 (39%). This is largely because companies have only increased dividends by 7% over the last year, while earnings are +20% higher due in large part to last years tax cuts. The current payout ratio is lower than the 2006-2017 long-term average of 41%, indicating it should be sustainable.

#3. Buybacks are a smaller portion of operating earnings now (54% for the 12 months ending June 2018) than in either 2015 (65%) or 2016 (58%). They are, however, somewhat higher than 2017, when 49% of operating earnings went to repurchase stock.

#4. On an absolute basis, the buyback numbers are pretty staggering.

In the 12 months ending June 2018, the companies of the S&P 500 have repurchased $646 billion of their own stock.

That is 29% more than the annual period ending June 2018 ($501 billion) and 24% higher than 2017s buyback total of $519 billion.

As we mentioned yesterday, mutual fund/ETF redemptions from US stock funds total $76 billion in 2018. Now you see why that doesnt matter to the direction of US equities.

Our one key takeaway from all this: as an aggregate, S&P 500 companies actually have a small buffer where earnings could decline by 10% from current levels and buybacks/dividends could remain steady. Point #1 shows that math. We doubt every company would do this, of course. Once earnings start to slip, boards and managers tend to grow defensive. But the cash should be there, and this math doesnt even include repatriation of capital from offshore domiciles (something the new tax code essentially encourages).

More generally, the dividend payout ratios (Point #2) also show that S&P 500 companies have plenty of cash flow coverage to hold payouts constant during the next downturn in earnings/economic recession. Three Fed rate cuts (a rational expectation in a recession) from current levels would bring 1-year yields back on par with the current S&P 500 yield. This should support equity prices until any recovery.

Bottom line: US stock buybacks have grown this year because operating earnings have grown by even more. It is the differential that matters, and for the moment it favors investors. And just like dividends, you cant restate a buyback either.