Opinion

James Saft

Equities face hurdles after buyback boom fizzles: James Saft

August 14, 2014

By James Saft

(Reuters) – Share buybacks by U.S. corporations, a key source of support for equity prices in recent years, are slowing, raising questions over why and what it will mean.

Second-quarter buybacks were 20 percent below those in the first quarter among a universe of 700 companies followed by quant analysts at Societe Generale, and are now lower than they were in the second quarter of last year. In a broader universe followed by S&P Dow Jones Indices, buybacks fell 30 percent in the second quarter compared to the first.

Given that the S&P 500 index ended the quarter more than 20 percent up on a year before, it is clear we are now experiencing a diminishing effect from share buybacks, something which may well test comfortable assumptions about share valuations.

“The questions to ask going forward are then the following; how much of the recent slump in corporate debt issuance is a function of QE tapering, increasingly stretched balance sheets, or simply a realization that continuing to leverage up the balance sheet to buy back equity at these levels is rather silly?” Andrew Lapthorne of Societe Generale writes in a note to clients.

“Whatever the reason, the absence of the largest buyers of U.S. equity going forward is likely to have significant consequence on stock prices.”

Corporate America has been on a buyback binge, repurchasing more than $500 billion of shares in the year to March 31. This has helped per-share earnings grow handsomely even without strong growth in sales. That, in combination with the fact that companies are often buying back shares with one hand while handing them out to employees with the other, has prompted criticism of the phenomenon. Socgen estimates that about 25 percent are used to pay for maturing management stock options, though that figure is considerably higher in some industries like technology.

And while tech companies like Apple and IBM have had among the largest and most aggressive programs, the vogue for buybacks has spread across sectors, with many mature industrial companies also buying back lots of issuance.

All of this has undoubtedly supported equity prices, both by cutting supply and by making earnings figures at least appear more attractively valued.

BUYBACKS AND THE END OF QE

Of course much of this has not been done with free cash flow. Rather the boom in share buybacks has coincided with a boom in debt issuance, meaning that companies are in essence taking on leverage with which to buy back equity.

Gross corporate debt has risen from about 55 percent of U.S. GDP just before the recession to 65 percent today. That has slumped recently though, with the quarterly change in nonfinancial corporate debt issuance falling to near zero, from more than 10 percent growth in the early part of the year.

One possibility is that this is a delayed reaction to the tapering by the Federal Reserve. Quantitative easing works, in theory, by forcing investors to find new assets to hold when the Fed buys up their safe holdings of Treasuries or mortgage-backed debt. So even though the Fed doesn’t buy corporate debt, it creates a friendly atmosphere for corporate borrowers because so many investors are holding cash and looking for a bit more yield.

But while corporations are still finding it easy to issue debt, it is true that the yield spread (the premium demanded above Treasury yields) for some borrowers has widened in recent months. Though most higher-rated corporate bonds are pricing as well as ever compared to Treasuries, the spreads on BBB issuer bonds have widened by about 10 percent in the past month. High-yield or so-called junk bond issuers are having a worse time of it, with the yield premium investors demand up by more than 15 percent.

Those are small changes in absolute yield, but perhaps indicative of a change in the wind.

As QE winds down this autumn, we may well see these trends accelerate, with fewer corporations issuing debt and investors wanting more compensation for holding it.

That could leave equities in a tricky situation.

If taking on more leverage to buy back shares is no longer seen as the way forward, companies may have to actually increase sales in order to show continued growth in earnings. At the same time, in a tighter debt market, expect investors to impose more of a risk premium on companies with stretched balance sheets.

Leverage, like whisky, feels lovely while you are adding it, but has distressing effects often when you stop.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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