Warren Buffett, the billionaire investor, recently hit the headlines with the announcement that he plans to spend almost $1 billion buying back shares in his investment company, Berkshire Hathaway. This practice has been increasingly common over recent years, with major implications.
Buybacks have fundamentally altered the investment landscape over recent years. However, this is not without long term consequences. Higher shareholder payouts today risk lower long term growth. Investors should be careful what they wish for.
Share buybacks are where a company repurchases its own shares in the open market. Similar to dividends, it is a way for companies to return cash to shareholders. Shareholders can either opt to sell their shares back to the company in exchange for a cash payment, or they can do nothing and keep the shares. If they choose the second option, they hold a larger percentage of the company than they did before the buyback (because the number of shares in the company declines by the number bought back but their personal shareholding does not).
Individual investors should also consider the tax implications – dividends are taxed as income whereas share sales in a buyback programme are taxed as capital gains (which can be a lower rate).
Unlike dividends, buybacks are a much more flexible use of a company’s cash. Dividends represent an ongoing commitment because cutting them sends out a negative signal about the company’s future prospects. In contrast, with buybacks, there is no ongoing commitment once the announced programme is complete.
1. Buybacks swamp dividend payments
Buybacks first came to the fore in the 1980s thanks to a change in US legislation which formalised their legality (previously there were concerns that they amounted to insider trading). They are now a far more popular way for companies to return cash to shareholders than dividends.
As the chart below shows, US companies spent around $200 billion in buybacks and around $100 billion in dividends in the year to June 2018. Compare that with around $30 billion of each 20 years earlier.
2. Large payouts to shareholders signal a warning about corporate sentiment
Companies can either choose to retain money within the business and reinvest it for future growth or return it to shareholders.
Depending on which way you look at it, a decision to distribute significant amounts of money to shareholders through buybacks is either a good thing or a bad thing.
If there are no sufficiently attractive opportunities, then it is better that companies return cash to shareholders than invest it wastefully. That is the responsible thing to do.
However, to the extent that high payouts indicate a dearth of investment opportunities then that is also a concern. The fact that that companies have been paying out around 100% of their profits through a combination of dividends and buybacks over recent years (this figure is known as the payout ratio) could be deemed as worrying. This compares with around 60% in June 2009.
Such high levels of payouts are all the more of concern as they have remained high against a backdrop of a strong US growth cycle and tax incentives for companies to invest. One interpretation is that companies remain very gloomy about the longer-term outlook.
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3. Such high payouts are unsustainable without severe long term consequences
High payouts might seem attractive to an investor but they doesn’t leave companies much room for future reinvestment.
Higher payout ratios could reduce the long-term sustainable growth rate of a company.
The sustainable growth rate is the maximum long run increase in sales that a business can achieve without having to raise additional capital or increase its leverage.
Mathematically, the sustainable growth rate is the amount of money retained in a company (which equals one minus the payout ratio) multiplied by the rate of return the company can make with that money (known as the return on equity).
Using the US as an example, the chart below shows the long run sustainable growth rate of the market based on different levels of payout ratio and assuming the return on equity is in line with the long term average since 1975.
If companies are paying out 20% of their profits then the long run sustainable growth rate of the market is around 11%.
However, if total payout ratios remain close to 100% on a long term basis, the sustainable growth rate will also decline towards 0%. This would be a catastrophic result.
4. Companies have been the dominant buyer of equities over recent years…the US is most at risk of a reversal
This has been through a combination of buybacks and mergers & acquisitions, with a roughly 50/50 split of each.
This is a problem. Despite equities having been on a storming bull run for the best part of a decade, they are unloved by most investors. The scars of the financial crisis run deep. In addition, many institutional investors, such as pension funds, have been reducing their equity allocations over time to de-risk and better match their liabilities. Bonds and alternative assets have been more in favour.
Were it not for corporate buying, it is unlikely that US equities would have generated the returns they have managed over recent years.
This begs the question of what will happen if this support wanes and who will pick up the slack?
Cash balances remain high which means that companies can continue to support buyback programmes in the near term. However, such high payout levels are unsustainable in the long run. The risks are tilted more to the US, where buybacks have been more popular.
While there are fundamental reasons for the outperformance of the US market over recent years, the presence of a consistent source of demand cannot have done any harm. Any change could see the tables start to turn in favour of non-US markets.
5. Low yields have supported buybacks…will this reverse as yields rise?
One reason buybacks have risen is because low yields have made debt a relatively attractive source of financing for companies, so much so that they have been borrowing money to buy back their shares. Apple has been the poster boy of this trade, having raised and spent billions of dollars in recent years to this end. A big question is whether higher interest rates remove this leg of support for the equity market, spelling trouble ahead for investors.
6. Buybacks support corporate window-dressing (and executive compensation)
Because buybacks reduce the number of shares outstanding, they can magically generate earnings per share (EPS) growth even when there is no earnings growth. Consider a stylised example, where a company has five shares outstanding and $100 of earnings. That equates to EPS of $20 ($100/5). In a year’s time, let’s assume that earnings have stayed flat at $100 but the company has bought back one share. EPS is now $25 (100/4) and EPS growth of 25% has been manufactured from nothing.
While this example is invented, the practice is very real. Over 70% of companies in the S&P 500 reduced their number of shares outstanding between the third quarter of 2017 and the third quarter of 2018, providing a tailwind to their reported EPS growth. Around 20% received more than a 4% boost from this source. To use Apple as an example, it has almost 20% fewer shares outstanding at the end of October 2018 than four years earlier, providing a healthy boost to its reported EPS.
A worrying consequence and motivation for such financial engineering is executive compensation. Many compensation programmes are tied to measures such as EPS growth and share price performance. By boosting EPS and injecting additional demand for a company’s shares, buybacks can in turn increase the amount of money a director can take home. At its worst, when this is unchecked, a poorly designed compensation package risks prioritising short term personal gain over longer term prospects.