At present, nearly two years after the Covid-19 induced economic meltdown, the SP500 has surpassed its’ February 2020 highs by nearly 30%, which means stocks have performed significantly better than they would on average over the past two years based on the SP500s average historical annual return of 10.5% (Maverick, 2022).
Sound’s pretty awesome, right? Well, not entirely. Numerous indicators of market overvaluation are raising big red flags at the moment. For example, the Buffett Indicator, which compares stock market prices to GDP, is at 199% (a fairly valued market should read 120%) (CMV, 2022). This is only slightly lower than its historical peak in December 2021 (218%), reflecting the current war in Ukraine, amongst other factors. In fact, the last time the Buffett Indicator was even remotely close to its current reading was at the height of the Internet Bubble in 2001. Yikes.
What could be driving these crazy prices? Is it the rising popularity of retail investing that’s breaking down the barriers of who can inject capital into capital markets? Or is it the result of quantitative easing as part of the Governments’ economic relief package? Or is it just a result of good old-fashioned inflation as things are getting more expensive, and stocks are no exception? Finally, could these high valuations just be reflective of outstanding corporate performance?
All of these are plausible explanations, but the graph below really grabbed my attention when it came to identifying a dark horse that is driving the market’s bull run–the name of this dark horse: The Buyback.
(Roberts, 2021) | Originally produced by Pavilion Global Markets using Bloomberg Terminal Data
This graph shows us that stock buybacks at the end of 2021 have driven roughly 40% of all SP500 returns (Roberts, 2021). In 2021, corporations that comprise the Dow Jones spent $848 billion dollars repurchasing their shares from markets (Idzelis, 2021). What’s worse is that buybacks are not expected to subside going into 2022; in fact, Deutsche Analysts forecast that this number could rise to a trillion US dollars over the next 12 months (Idzelis, 2021). The result could be an even more overvalued market – as put by Bob Johnson, CEO of the American College of Financial Services, “the more overvalued the market, the farther the potential fall” (Carlozo, 2017).
So what are buybacks and why do corporations love them so much? If you own a company and have excess cash, there are four ways of putting that cash to work: organic growth (investing in your business); inorganic growth (acquiring a stake in another business); dividends (returning funds to shareholders); finally, share repurchases (buybacks, another way of returning funds to shareholders). A buyback occurs when a public company uses its free cash to repurchase its outstanding shares on the market. Naturally, this reduces the supply of shares while demand stays constant, often resulting in a jump in share price (Wohlner, 2021). Further, buybacks boost Earnings per Share (EPS), a standard metric for judging company performance, by reducing the number of shares outstanding (Wohlner, 2021). A higher EPS can boost demand by incentivising investors to buy the stock under the impression that the underlying company is performing well, which further pushes up the stock price.
A buyback can be an extremely effective way to boost share price. The problem is that it does so without improving any fundamental aspects of the underlying business, hence causing market price to deviate from intrinsic value. Further, using cash for share repurchases is an opportunity cost, as that cash could have been used for capital expenditures such as upgrading facilities, investing in Research and Development, or Marketing, which are legitimate improvements to business fundamentals (Maurer, 2021). For these reasons, buybacks are often referred to as “value destructive” in the long term. All considered, one could argue that buybacks excite the average (often financially illiterate) retail investor or speculator, as they create an illusion of improved company performance without actually improving company performance.
Another common criticism of buybacks is that company executives sometimes abuse them to reach quarterly EPS targets that determine levels of bonus compensation (Shorter, 2020; Clifford, 2017). Historically, CEOs have received about half of their overall compensation in bonuses (Jensen and Murphy, 1990). When hitting an EPS target directly determines how many millions of dollars an executive will take home, it is understandable that many would opt for a share repurchase to push them over the edge. Notwithstanding, I always thought one’s purpose as a company executive was to maximise long-term shareholder value rather than line their pockets as much as possible. Thankfully, not all companies compensate their CEO based on EPS, but it’s still true that basing bonuses on any type of easily-manipulated financial performance indicator calls for self-serving behaviour.
As the gap between Market Price and Intrinsic Value grows wider, the market finds itself in bubble territory, where massive corrections (and even crashes) can be commonplace. Considering that U.S. markets are currently very overvalued and that the world economy may be expecting some turbulence (international relations, supply chain issues, rising interest rates, coronavirus, inflation etc.,), it seems that investors may have a serious cause for concern on their hands. Furthermore, as already established, buybacks are only projected to become more popular amongst corporations.
While it appears clear that buybacks play a role in driving market overvaluation, this is not to say that they do not present benefits to corporations in certain cases. Studies have shown that buybacks reduce market-wide volatility, as companies are unlikely to sell their own shares when fearful of bad performance (Lewis and White, 2021). Buybacks can also provide “substantial liquidity that facilitates orderly trading and reduces transaction costs for retail investors” (Lewis and White, 2021). Finally, buybacks can objectively be a smart decision in certain cases. For example, Warren Buffett, who is famously against stock repurchases on the whole, recommends buybacks when a company finds its stock to be undervalued (Rosenbaum, 2018). By repurchasing shares at an undervalued price and selling them at a fair or overvalued price, companies can generate a cash profit that can be invested to further grow the business.
Furthermore, one cannot forget that while large sums of cash are spent on repurchases yearly, large sums are also spent on share issuances, which have an opposite effect on stock market prices. This means buybacks are often used as a means to offset the negative effects of excessive stock issuances (Maurer, 2021). Ultimately, buybacks are just a way of returning excess funds to shareholders. Often, they present a tax-advantaged way of doing this, as dividends are often subject to capital gains tax (Nath, 2021).
Like most financial strategy decisions, binary thinking does not fly; buybacks are not intrinsically “good” or “bad”. In a case where an undervalued company has healthy cash flow, cash reserves for a “rainy day”, and no plans (or need) for significant capital expenditures on the horizon, share repurchases would by no means be a bad decision. But let’s remember the reason for this discussion: markets are currently overvalued. Assuming that the graph produced by Pavilion Global Markets is soundly constructed, the increasing popularity of buybacks is a significant reason for this overvaluation. Regardless of the liquidity and volatility benefits of buybacks, the fact that corporations can allocate large sums to the repurchase of their already overvalued shares, which over time has contributed significantly to market-wide overvaluations, is potentially dangerous to many investors. This is especially true if the macroeconomic factors mentioned begin to generate significant sell pressure.
Further discussion
The debate around buybacks sparks two key discussions surrounding corporate finance activities and reporting. For one, questions arise regarding pop business news’ and retail investors’ fixation on earnings, which in reality have a weak correlation (0.46r2) with changes in share price and can be easily manipulated (Stern, 1974). This fixation allows buybacks to boost demand through raising a company’s EPS figure. Secondly, the fact that many executive bonus schemes are also fixated on EPS targets (with compensation being paid in company stock) arguably provides too much incentive for managers to repurchase shares. Perhaps we need to pivot away from focussing on earnings and instead pay more attention to the real driver of share price movement, cash flow (0.92r2) (Stern, 1974). Regardless, it is very important that retail investors understand the effects of buybacks on company stock and appreciate the ramifications of these effects on the market.
Reference list
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Clifford, S. (2017). How Companies Actually Decide What to Pay CEOs. [online] The Atlantic. Available at: https://www.theatlantic.com/business/archive/2017/06/how-companies-decide-ceo-pay/530127/.
CMV (2022). Buffett Indicator Shows Stock Market is Overvalued. [online] www.currentmarketvaluation.com. Available at: https://www.currentmarketvaluation.com/models/buffett-indicator.php.
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Idzelis, C. (2021). Stock buybacks can keep surging next year after a potential record for 2021, analysts say. [online] MarketWatch. Available at: https://www.marketwatch.com/story/stock-buybacks-can-keep-surging-next-year-after-a-potential-record-for-2021-analysts-say-11639752750 [Accessed 18 Jan. 2022].
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Roberts, L. (2021). 40% Of The Bull Market Is Due Solely To Buybacks. [online] Available at: https://www.advisorperspectives.com/commentaries/2021/11/03/40-of-the-bull-market-is-due-solely-to-buybacks.
Rosenbaum, E. (2018). Warren Buffett explains the enduring power of stock buybacks for long-term investors. [online] CNBC. Available at: https://www.cnbc.com/2018/08/31/warren-buffett-explains-the-enduring-power-of-stock-buybacks.html.
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Stern, J.M. (1974). Earnings per Share Don’t Count. Financial Analysts Journal, [online] 30(4), pp.39–75. Available at: https://www.jstor.org/stable/4529716?seq=1#metadata_info_tab_contents [Accessed 18 Jan. 2022].
Wohlner, R. (2019). Are Stock Buybacks a Good Thing or Not? [online] Investopedia. Available at: https://www.investopedia.com/articles/financial-advisors/121415/stock-buybacks-good-thing-or-not.asp.