In a recent feature, Nicolas Colas, co-founder of DataTrek, shared his insights on stock buybacks and what they could mean for the market moving thorrugh the year. Traders Magazine is reprinting his research withpermission below in its entirety.
S&P released their latest data on US stock buybacks yesterday, so lets review what they had to say and draw some conclusions about the current investment environment.
Starting with three points from 2018:
#1. The headline numbers are off the charts.
Buybacks in Q4 2018 for the companies of the S&P 500 totaled $223 billion, a new quarterly high and 30% above the prior cycle top of $172 billion in Q3 2007.
For 2018, buybacks totaled $806 billion, up 55% from 2017. Last year was also meaningfully higher than both the current cycle top of $572 billion (2015) and the prior cycles $589 billion (2007).
Companies didnt only spend their windfall from lower corporate taxes on buybacks. Operating earnings grew by $216 billion last year from both tax cuts and business growth. Buybacks increased by $287 billion.
#2. Over half the growth in buybacks last year came from one sector – Technology – and 80% came from just 3 industries.
Tech industry buybacks grew by $160 billion in 2018, to $279 billion from $119 billion. This represents 56% of all 2018 buyback growth.
Apple alone is responsible for 14% of total growth in 2019 buybacks, with an incremental $40 billion in repurchases last year.
Health Care ($44 billion of incremental 2018 buybacks) and Financials ($26 billion) represent 15% and 9%, respectively.
These three sectors represent 80% of all growth in 2018 buybacks over 2017.
#3. Just as important as the top-of-house numbers: how did companies allocate their free cash flow between buybacks and dividends in 2018?
In 2019, S&P 500 companies used 63% of their operating earnings (post tax) on buybacks. This compares to a 50% average buyback payout ratio from 2010 – 2017.
The comparable dividend payout ratio (total dividends divided by post tax operating earnings) in 2018 was 36%, as compared to 39% for 2010 – 2017.
While companies obviously skewed their shareholder payments to buybacks in 2018, dividends did actually grow at their fastest pace since 2015. Dividends paid increased 8.7% last year, better than 2017 (5.7%) and 2016 (3.9%).
The important question now: how will buybacks play out in 2019? They remain, after all, a central source of US stock demand:
Investment Company Institute data shows that in 2018 holders of US equity mutual funds and ETFs redeemed $114 billion out of these products.
If you thought a 4.2% decline for the S&P 500 in 2018 was disappointing, how much worse would it have been if S&P companies hadnt bought $287 billion more stock over the year than they did in 2017? Or $806 billion in total?
Answering that query is essentially a corporate finance exercise with three variables:
Payout ratios. S&P companies are currently spending ALL their post-tax operating earnings on buybacks and dividends. In 2018, dividend payments plus buyback expenditures totaled 99% of earnings. From 2015 – 2017, the average total payout ratio was also 99%. While there were worries earlier this year that companies would use some of their cash flows to pay down debt, the move lower for interest rates in 2019 makes that less likely.
Future earnings expectations. By Wall Street analysts reckoning, 2019 is shaping up to be a tale of 2 halves. First half will see a 4% earnings decline for Q1 and flat earnings in Q2. Third quarter should see a return to modest growth (+2%) and Q4 may be better still (+8%). For the year, they expect 4% bottom line growth.
Management/board decisions about dividend vs. buyback policy. After bumping dividends by 9% last year, companies may prefer to allocate a greater portion of incremental cash flows to buybacks. Dividends, after all, are meant to be signals about long-term earnings growth. If the analysts are right about 2019, managements will be wary about raising dividends too much this year.
Our conclusion: buyback levels in 2019 should remain broadly consistent with 2018, but – and this is a big but – earnings have to remain constant to last year to make that happen. With buyback payout ratios at cycle highs and dividend + buyout ratios at 100%, there is simply no buffer. This important source of demand for equities (especially in Tech, Health Care and Financials) will flow with the earnings tide.
S&P report: https://www.prnewswire.com/news-releases/sp-500-q4-2018-buybacks-set-4th-consecutive-quarterly-record-at-223-billion-2018-sets-record-806-billion-300817734.html