Over the past several months, the issue of stock buybacks has been hotly debated by both politicians and the media. Defenders of the practice say buybacks are just a way for companies to return cash to shareholders and reinvest earnings, while opponents claim they benefit only a small group of people while siphoning capital away from better investments.
In February, Senators Chuck Schumer and Bernie Sanders penned an op-ed in the New York Times calling for legislators to impose a ban on stock buybacks, while Senator Marco Rubio suggested a less aggressive solution that would remove the tax incentives that encourage buybacks.
Unsurprisingly, major financial institutions have mostly been in favor of leaving buybacks untouched. Some have argued they do not have a significant effect on the market and, as such, do not represent a problem that needs to be solved at all; while others argue buybacks are an integral part of the modern financial machine that cannot and should not be removed lest the system come crashing down. A recent report from Goldman Sachs (GS, Financial) falls firmly into this second category. The investment bank lists five consequences of banning buybacks.
Slow earnings per share growth
Buybacks by their very nature reduce the number of shares outstanding. So while earnings themselves are not increasing, earnings per share will increase just as a consequence of this reduction. Accordingly, banning buybacks will cause earnings per share growth to slow down. In particular, earnings growth has historically trailed earnings per share growth. The report goes on to say that:
“During the past 15 years, the gap between EPS growth and earnings growth for the median S&P 500 company averaged 260 bp (11% vs. 8%). In 2018, the spread equaled 200 bp (20% vs. 18%).”
Change cash spending
According to Goldman, S&P 500 companies have allocated an average of 25% of their annual cash spending to buybacks since 2009. If buybacks are suddenly made illegal, these companies will have to find other uses for this capital. This, of course, is a key point that proponents of a ban make - in the absence of buybacks, companies will have to reinvest into themselves, or so the thinking goes.
The investment bank does not think capital expenditures and research and development will rise significantly, however, given the absence of demand for such an expansion. Instead, Goldman thinks the cash will go toward dividend payments and merger and acquisition activity. While this is not in and of itself a reason why the market will suffer, it does point to the fact a ban is likely to be ineffective at curbing the flow of cash to shareholders.
Widen trading ranges
Banning buybacks will remove a major buyer from the equity markets (the companies performing the buybacks). While this is somewhat of a technical point, it is worth thinking about. In the absence of these big buyers, volatility is likely to increase, particularly to the downside, as companies will no longer be able to support the price of their stock by buying it up at low valuations.
This, of course, is an admission that buybacks do indeed affect the market in a very significant way. Increased volatility is undoubtedly a concern for investors, but the risk of an occasional volatile event should be balanced against the more systemic risk of artificially dampening the natural volatility inherent to the equity markets.
Reduce demand for shares
Leading on from the previous point - without buybacks, demand for equities will fall significantly, which will inevitably lead to the bottom falling out of the market. As the report says:
“Repurchases have consistently been the largest source of US equity demand. Since 2010, corporate demand for shares has far exceeded demand from all other investor categories combined. Net buybacks for all US equities averaged $420 billion annually during the past nine years. In contrast, during this period, average annual equity demand from households, mutual funds, pension funds, and foreign investors was less than $10 billion for each category – despite the fact these categories collectively own 83% of corporate equities. Buybacks represented the largest source of equity demand in 2018.”
Lower valuations
A slowdown in earnings per share growth will undoubtedly lead to decreased valuations. The fear is that falling valuations could spook investors, causing them to pull capital from the equity markets. Furthermore, the increased supply of shares on the market relative to falling demand will exert even more downward pressure. The combination of all of these factors could come together to create a perfect storm scenario that sees the market crash.
Regardless, it pays to think about how the market became so addicted to stock buybacks in the first place. Banning buybacks may cause a crash, but pretending this practice does not play a crucial role in supporting today’s inflated valuations is also not realistic.
Disclosure: The author owns no stocks mentioned.
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