Hopes rise that spare cash is now being spent on organic growth
One of the biggest drivers of the US equity bull run has retreated as the S&P 500 ventures further into record territory.
Ultra low interest rates and a paucity of investment choices in recent years has unleashed a tidal wave of share buybacks by S&P 500 companies, notably from the likes of Apple and other big members of the index.
Share buybacks have tallied $1.559tn since the start of 2011 according to S&P Dow Jones Indices. During this period, buybacks peaked during the first quarter of 2014, to the tune of $159.28bn, before slipping to a provisional figure of $120.21bn for the second quarter.
Investors like share buybacks and typically view them as a sign from management that the company’s stock price is cheap. Reducing the amount of outstanding shares helps boost earnings, with around a quarter of buybacks accounting for paying maturing options granted to employees.
A less charitable view is that a big buyback reflects a company with too much cash and lacking good ideas about investing in their business or making a major acquisition.
The boom in buybacks also owes much to the Federal Reserve’s suppression of long term interest rates via quantitative easing and stagnant growth in Europe, an important foreign market for many S&P 500 global companies.
Record low interest rates in the corporate bond market have helped fund large buybacks, but with the central bank on course to conclude buying bonds under QE in October, fuel for buybacks is ebbing and non-financial debt issuance has slowed.
Andrew Lapthorne at Société Générale says companies have exploited the generosity of financial markets to fund their share buybacks and as that fades, the equity bull market faces losing a key source of support.
“The absence of the largest buyers of US equity going forward is likely to have significant consequence on stock prices,” he says.
With the S&P 500 just shy of the 2,000 point threshold and the Fed ending QE, the economics behind buybacks are clearly no longer as compelling.
That in turn raises an important question for equity bulls: what drives prices higher should buybacks retreat further? The best case scenario answer is that we have reached a point in the cycle where companies finally look at spending more of their excess cash on organic growth opportunities and acquisitions now that buybacks are more costly.
Certainly investors are sending that message as stocks extend their gains for the year.
“The attractiveness of Capex and mergers and acquisitions has increased because share prices have gone up,” says Peter Stournaras, portfolio manager at BlackRock.
“The market is rewarding companies investing for growth though Capex and M&A.”
Over the past year, companies buying back their own shares have outperformed other companies issuing shares by some 5 per cent, estimates Vadim Zlotnikov, chief market strategist at AllianceBernstein.
Normally such outperformance over an extended period of time runs around 1 per cent, so clearly the market has rewarded companies buying back their stock over the past year.
A slowing pace of buybacks, however has seen the degree of outperformance over the past three months narrow to 0.7 per cent says Mr Zlotnikov.
All of which underlines the importance of the economy gaining altitude and companies deploying their excess cash into operations and funding acquisitions that can boost revenues in the coming months.
That remains the bull case for equities and such an outcome would alleviate any concern over ebbing buybacks.
A looming danger entails companies being less optimistic about the economy and struggling to significantly boost their top line growth.
For now, the market ignores any comparison with 2007, when third quarter buybacks reached $171.95bn and the S&P 500 rallied into then record territory the following month.
We may well discover that a further reduction in buybacks does not pave room for an extended business cycle and therefore removes a key prop for equities.
Reducing the potency of a major buyer from any market usually means lower prices.