Twenty-five years ago, when I first started in the City, I remember share buybacks being viewed as a sign of weakness, a policy of last resort once all other growth options had been exhausted.
To be fair, it was already a more established trend in the US, corporates there having shifted from a predominantly “retain-and-invest” approach to a regime of “downsize-and-distribute”. However, the buyback trend has now reached fever pitch in the US, with FactSet reporting that companies spent more on buybacks in the 12 months to the end of the second quarter than they generated in free cashflow.
The UK equities team here at M&G are not big fans of buybacks, preferring instead enhanced, progressive dividends and specials when there is a clear excess of capital over that required for growth.
Our reasoning is multifold. First, from a signal of confidence point of view, an enhanced base dividend shows greater commitment to ongoing long-term shareholders – a declaration of marriage rather than casual dating. Second and critically, the harsh reality of buybacks is that they tend to be very cyclical in nature, rising in bull markets and falling in bear markets. It is rare indeed for companies that do buybacks to resell the shares at higher prices.
Take GE, for example, which spent $3.2bn on buybacks in the first three quarters of 2008, at an average price of $31.84, only to be forced, as the global financial crisis took effect in the fourth quarter, into a $12bn issue at just $22.25 per share.
With US buybacks and dividend payments on course to exceed $1 trillion for the first time this year, the mounting concern for many is that this leaves precious little capital left for investing in future growth. While increasing dividends serves to deliver immediate returns to shareholders, the reluctance to boost capital investment in operations, people and innovative products has left US corporates with the oldest plant and equipment in almost 60 years, with the average age of fixed assets reaching 22 years in 2013.
Flattering the present while handicapping the future in this way has the effect of bringing forward future earnings potential, benefiting today’s shareholders at the expense of tomorrow’s.
At the aggregate all-economy level, the relative lack of new productive capacity potentially condemns the US to a slower achievable growth outlook. Add to this the obvious point that, with corporates increasingly using cheap debt to buy their expensive equity, at some stage borrowing costs will rise, making the costs of servicing the debt increase, again diverting capital into unproductive but unavoidable areas and away from investment for growth. This all suggests that the weak productivity numbers that the US economy has generated for too long are not about to improve.
A recent Barclays report stated that “companies in the S&P 500 have repurchased $2.6 trillion of stock in the last five years… more than the Federal Reserve spent on quantitative easing and equat[ing] to 15 per cent of the market capitalisation of the S&P 500.” Whichever way you look at it, buybacks have proved a huge prop to market levels on Wall Street – and of course to the earnings-based compensation that US company chief executives award themselves.
So it is concerning that, just as financial markets brace for the first rise in US rates for nearly a decade, impacting the availability of cheap credit to fund the buybacks, the US corporate world is registering an “earnings recession”, with back-to-back quarters of aggregate earnings declines. These two negatives in combination do little to help justify a market valuation that on a cyclically-adjusted price/earnings (CAPE) basis is some two-thirds above the very long-term average. This is surely good reason to remain cautious on the outlook for the world’s biggest equity market.
On the basis that empirical evidence tells us that the old adage “when Wall Street sneezes, the rest of the world catches a cold” is truer now than ever, this must represent a clear and present danger for investors in the UK market.