The following item appeared in a recent newsletter by Nicolas Colas, co-founder of DataTrek.
US stock buybacks are much in the news of late, a plug-and-play narrative for a range of issues. They get the credit for domestic equities sitting near all time highs and the blame for low wage growth and income equality. We only know this: once a grimy financial topic like corporate asset allocation hits the mainstream, it will likely be twisted beyond recognition. And thats exactly what has happened…
To clear some of the air around the topic – and consider what buybacks actually say about current US equity prices – we went to the S&P Dow Jones Indices and pulled the data for dividends and buybacks for the 500 back to the beginning of 2006. Heres what we found:
#1. It is actually fair to say large US public companies have a reinvestment problem, but it goes back much further than just the last 12 months (when the criticism about buybacks really kicked into high gear). The numbers:
In 2006 the companies of the S&P 500 paid out 89% of their operating earnings in the form of buybacks and dividends. That left only 11% to be reinvested in their businesses, saved as cash, used to pay down debt, or to fund acquisitions.
In 2017, that buyback/dividend payout ratio was 88% – essentially the same as 2006.
In the 11 years in between, aggregate (dividends plus buybacks) payout ratios show exactly what you would expect: tremendous cyclicality. They peaked in 2008, at 136% of operating earnings, and troughed in the 4 quarters ending Q1 2010 at 60%.
The bottom line here is that by the time a company is large enough to be included in the S&P 500, its incremental capital needs in excess of depreciation/amortization are largely behind it. If the company spends a lot on R&D, this tends to grow in line with revenues and therefore not crimp earnings/cash flow at the margin either. Operating cash flow therefore can go into the bank (at low returns), pay off debt (also low return), to make an acquisition (a risky return, and historically subpar), or pay for dividends and buybacks. The last 2 at least have the advantage of signaling earnings power or covering the companys cost of capital.
#2. Contrary to popular belief, stock buybacks in the S&P 500 are not at all-time highs. The data here:
The annual record for cash spent on buybacks was back in 2007, at $589 billion.
The trailing 4-quarter peak in the current cycle is also $589 billion, in Q1 2016. When you inflation-adjust the 2007 numbers, however, it works out to $706 billion in todays dollars.
In 2017, S&P 500 companies bought back $519 billion of their own stock, or 12% below the 2016 highs.
This neatly knocks out the narrative that US stocks are near all-time highs simply because of record buybacks. If the correlation were 100%, the S&P 500 would have topped out in Q1 2016 when 1-quarter buybacks totaled $161 billion. In Q4 2017 they were just $137 billion.
#3. An offsetting negative, however: companies dont buy back their stocks because they are Cheap. Rather, they repurchase equity when they have the free cash flow to do so. Some points to consider:
At the top of the prior cycle, the S&P 500 peaked in mid 2007. And so did stock buybacks, at $172 billion for Q3 2007.
The S&P 500 made its last cycle low in Q1 2009 and buybacks hit their low point the next quarter, at just $24 billion. Yes, buyback levels declined by 86% in less than 2 years.
Even as stocks recovered from their 2009 lows, S&P 500 companies did not come rushing back in to buy back their shares. In 2010, for example, buybacks totaled $299 billion, or basically half (49%) of the 2007 highs. The next year was better, at $405 billion, but still 31% below the peak.
This is a critical point to remember about buybacks: they go away when stocks are actually at their cheapest. They are, and always will be, a function of corporate confidence and free cash flow – not equity valuations.
#4. Companies actually spent less on buybacks/dividends in 2017 than the average of 2014 – 2016. The numbers:
From 2014 to 2016, the companies of the S&P 500 paid out 99.8% of their operating earnings on buybacks and dividends.
Last year, that ratio fell to 87.6%.
There are many issues at work here, of course. Perhaps companies eased up on buybacks because the US equity market had a banner year in 2017. Or maybe they viewed the DC regulatory environment as more friendly to business and chose to reinvest cash earnings last year. The math, however, is clear enough: dividends and buybacks are a smaller percentage of operating earnings now than 1-3 years ago.
So what does all this mean for US equity investors today? Three final points:
Buybacks and dividends have taken the lions share of operating earnings for a long time; this is nothing new. The ratio here averaged 87.2% from 2010 – 2016, and corporate earnings still rose by 35% over the same period.
While we didnt highlight the numbers, dividends actually matter a lot more than buybacks to share prices when volatility strikes. Aggregate dividend payments for the S&P 500 companies fell by 24% from 2007 to 2009 versus the 86% decline in buyback levels.
While Q1 2018 buyback totals are not yet available, were a long way from Peak buyback. Just to get back to the Q1 2016 highs ($161 billion) would mean an 18% increase from Q4 2017 levels.