PMC Weekly Review - July 15, 2019
Stock buybacks have been one of the highly debated themes of 2019 and have invoked strong opinions from multiple sides, including Wall Street gurus, investors, and even politicians. For some, share repurchases are the work of a devil driving share prices and the stock market higher and contributing to income inequality. On the other side, advocates of buybacks believe, it is an efficient corporate finance tool for distributing wealth back to shareholders. So, who has it right, or is there a middle ground to be had between these dissenting opinions?
Many may not know that up until the 1980s, share repurchases were considered a form of market manipulation and were illegal. However, the U.S. Securities and Exchange Commission changed its stance and legalized them with the introduction of the 10b-18 rule in 1982. The rationale behind this change was that a buyback would serve as an alternative method of rewarding shareholders while using idle cash reserves. It would ensure stability in share value, which is often used as collateral by loan issuers, insurance companies, and other financial institutions, and could be implemented as an antitakeover strategy. Since then, buybacks have increased steadily and have surpassed dividend distribution for almost all years since 1997. When financed with excess cash or profits, buybacks are an attractive way to return cash to shareholders, and investors typically embrace buybacks.
An alternative method of funding their use is known as leveraged buybacks, in which the company uses debt to repurchase its shares, a scenario often more prevalent in small cap companies. The current extended bull market rally is largely supported by these leveraged buybacks, as many companies have financed buybacks through low-interest debt. Many of these companies have grown increasingly more leveraged since 2009. Almost 34% of the repurchases in 2017 were funded by debt. According to Jeffrey Gundlach of Doubleline, this has turned the equity market into a Collateralized Debt Obligation residual that is getting thinner and riskier. Credit rating agencies have cautioned companies from undertaking excessive share buybacks, highlighting the conflict between the shareholder and creditors. Analysts at these credit rating agencies believe using cash to repay debt would improve the company’s long-term growth, beneficial for both creditors and shareholders. On the other hand, buybacks may only support stock prices in the short run, more often than not at the expense of creditors. For the first time in history, more corporate bonds are rated BBB than AAA. In a downturn, many bonds in the BBB category will transition to junk, and a few of these highly leveraged companies’ debt might transition to default.
In 2018, although the number of debt-funded buybacks dropped considerably and stood at 14% of the total, the overall buyback trend continued to grow, and the S&P 500 Index companies hit a new record, buying back more than $800 billion worth of shares. However, during this phase the buybacks were largely backed by the huge cash reserves US corporations accumulated following the Tax Cut and Jobs Act introduced in December 2017. The Act was introduced with an expectation that companies would invest the excess cash in things that contributed to their long-term growth such as reducing debt, capital expenditures, research and development, and higher wages. However, the companies chose to use the cash to repurchase shares from existing shareholders, rather than make capital expenditures. This reduced the number of shares outstanding, therefore increasing the earnings per share and, in turn, drove the stock price higher. This trend has continued in the first quarter of 2019, and buybacks are expected to reach a peak of $1 trillion this year.
With the drums rolling for the 2020 elections, buybacks are at the forefront of the political arena as well. According to several presidential candidates, buybacks do not encourage organic growth, and they mostly benefit the top executives, for whom the majority of compensation comes from stock options and stock-based incentives. Politicians have held buybacks responsible for increasing wealth inequality and have suggested restrictions or additional taxes to discourage such practices. At the moment, a more portentous question is: What will happen when these buybacks come to an end? Where will these highly leveraged companies, with unhappy creditors and ecstatic shareholders riding on the buyback- induced high, stand? Perhaps the current rating of BBB for General Electric’s (GE) debt with a negative outlook can serve as a snippet of the larger story. After spending billions on buybacks for almost half a decade, GE halted its purchases and reduced its dividend in 2017 to repay debt. Unhappy shareholders moved on to other opportunities, and GE’s share price nosedived.
Although not an evil in itself, the increasing number of buybacks in recent years without regard to fundamentals and valuations is worth pondering. Investors need to factor in buybacks before investing in any company. These buybacks may result in higher downside risk, especially when these firms have huge debt on their balance sheet. Additionally, fines or additional taxes may be imposed on companies that are resorting to the practice. For now, the jury is still out on stock buybacks, but a sudden turn in the market could change many investors’ perception of the practice.
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