Since 1980, share buybacks have grown exponentially and an increasing number of American companies have shown a preference for repurchasing shares over distributing wealth through dividends. While both are valid avenues for rewarding investors, buybacks provide the added benefit of reducing the outstanding share count of a company, leading to an increase in earnings per share even if net income remains the same.
Source: Harvard Business Review
The billions of dollars pumped by listed companies played an important role in pushing stock prices to record highs as well. The party, however, has come to an abrupt end as a result of the Covid-19 pandemic. This is something many analysts and investors did not factor into their earnings and market performance models. The sudden end to buyback programs may reveal deep financial issues for a few companies.
The first wave of buyback suspensions is here
Some companies have been forced to cut back on shareholder distributions. Airline operators are a classic example. In accordance with the terms and agreements of the federal aid program, these companies have to abandon both dividends and repurchases through Sept. 30. Other companies have voluntarily decided to do the same in a bid to save much-needed cash during these trying times. The big names that decided to suspend buybacks include:
- Dave & Buster’s Entertainment (PLAY, Financial)
- Bed Bath & Beyond (BBBY, Financial)
- Brinker International (EAT, Financial)
- Bank of America (BAC, Financial)
- Bank of New York Mellon (BK, Financial)
- Citigroup (C, Financial)
- Goldman Sachs (GS, Financial)
- JPMorgan Chase (JPM, Financial)
- Morgan Stanley (MS, Financial)
- State Street (STT, Financial)
- Wells Fargo (WFC, Financial)
According to data from Bloomberg, 39 other companies have decided to follow their example and cut back on buybacks. There is reason to believe that many more companies will do the same in the coming months. In a note, Goldman Sachs analyst David Kostin wrote:
“Reduced cash flows and select restrictions mandated as part of the Phase 3 fiscal legislation suggest more suspensions are likely. Higher volatility and lower equity valuations are among the likely consequences of reduced buybacks.”
In addition to creating a dent in current period income, the discontinuation of buybacks might lead to significant capital losses for several reasons.
Buybacks as a mechanism to improve per-share figures
From an outside perspective, a company repurchasing shares is simply distributing wealth to its shareholders. However, a deeper understanding of the concept reveals why companies prefer buybacks over dividends. It’s easier to analyze this matter using an example.
Apple Inc. (AAPL, Financial) has distributed billions of dollars to shareholders through this method, as exhibited in the below chart.
Source: Company filings
The billions of dollars spent by the company on buying their own shares have concealed the inability of the company to grow its net income. From 2015 to 2019, Apple’s net income grew 7.7%, according to Securities and Exchange Commission filings. In comparison, earnings per share increased by 29% over the same period. Investors, by looking at per-share earnings figures, assumed that Apple was firing from all cylinders, which is not true. The company retired millions of common shares using its buyback program and the significant reduction in the number of shares outstanding was driving this phenomenon.
In a hypothetical scenario where Apple is forced to suspend buybacks, the price-earnings multiple will expand drastically as a result of declining earnings per share. With over $100 billion in cash and short-term investments, the company is unlikely to cut distributions. However, there could be many companies, including airline operators and banks, who used repurchases to improve valuation multiples. The GuruFocus All-in-One Screener can be used to filter for companies that have repurchased shares while net income was declining. A suspension of buyback programs in these companies will most likely lead to a decline in the share price over the next several months.
Chris Wood, Jefferies global head of equity strategym wrote to clients in the last week of March:
“The problem for the U.S. equity asset class is that it began the downturn so overvalued at a record high valuation to sales. The other problem is that the leveraged share buyback game has ended, which also means an end to the phony earnings growth it produced.”
A cash-rich company will still survive the mayhem, but companies in poor financial health will fall victim in the next few months. An investor should ideally conduct thorough due diligence into the buyback trends of a company before hunting for bargains in this market.
The broad market performance might turn out to be disappointing
There’s more bad news for investors. According to Reynolds Strategy Chief Market Strategist Brian Reynolds, corporate buybacks have been the only net source of money entering the stock market since 2008. Contributions from all other sources—including exchange-traded funds, foreign buyers, insurers, mutual funds, broker-dealers, pensions, hedge funds, and households—netted out to roughly zero. This is a confirmation that repurchases have added much-needed liquidity to the market, which is something that cannot be expected in the coming months.
In an interview with the Wall Street Journal, EPFR analyst Winston Chua said, “In any given year, when buybacks and takeovers are greater than new offerings, the market tends to move higher.”
This is an additional confirmation that buybacks have played a significant role in the recent bull market that lasted more than a decade before the Covid-19 virus wreaked havoc. Without this support, U.S. markets might find it difficult this year to post attractive returns, even if the economy recovers in the second half of the year.
Suspension of buybacks might be a blessing in disguise
Amid all these dark clouds, there’s a silver lining for investors. As companies cut back on distributions to shareholders, retained earnings will grow exponentially. This, in return, will prompt company executives to search for value-accretive investment opportunities. Some companies might also look for acquisition candidates to scale up their business operations. In the long term, these types of investments will reward investors as a result of a massive boost to corporate earnings. Understandably, buybacks do not add any monetary value to the company in the long run. However, capital investments do. This is good news for investors.
Ed Clissold, Ned Davis Research chief U.S. strategist, shares the same view. In March, he said:
“Eliminating buybacks would make a difference. It would decrease the demand for stocks. But, if companies are growing earnings and are attractively valued, then there should be plenty of demand for stocks.”
The key is to identify companies that are in a position to weather the current storm and continue with their investment plans.
Takeaway: the true state of company earnings will be revealed in the future
With many companies having to suspend buybacks as a result of a severe decline in economic activities, investors will soon find out which companies were “swimming naked.” Company executives can use share repurchases to inflate the stock price. If shares are purchased above their respective intrinsic value, shareholder wealth will be destroyed. However, compensation attached to the market performance often leads company officials to make decisions that eventually hurt investors. But executed at the right price, buybacks will prove to be value accretive. Warren Buffett (Trades, Portfolio) is a huge fan of companies that do this. Ignoring companies that try to manipulate valuation multiples using buybacks and betting on companies that prioritize shareholder interests is a winning strategy under any market condition, which is exactly what investors should be focused on in the next few months.
Disclosure: I do not own any shares mentioned in this article.
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