Fueled by the reforms and special tax holiday initiated by the Tax Cuts & Jobs Act of 2017, stock buybacks accelerated to unprecedented levels last year. Indeed, 2018 saw companies buy back a staggering $1 trillion in stock. This massive wave of buybacks has sparked a political backlash, bringing the practice into public focus to a degree not witnessed in years, if ever before. A debate is now raging over the economic and social benefits of allowing stock buybacks. We have covered the evolution of this debate in past research notes.
A 2018 study published in the Financial Analysts Journal (FAJ) on the impact of stock buybacks on bull markets has recently gained the attention of the media, politicians, financial professionals and academics alike. The study’s findings are genuinely shocking. According to the authors, the level of buybacks explain the vast majority of the discrepancies between the performance of different stock markets around the world.
A groundbreaking analysis
The FAJ study analyzes the returns of stock markets in 43 countries between 1997 and 2017. That is a sweeping sample size, which lends credence to the durability of the study findings. It is easy to cherry-pick data for the purpose of an academic study. That did not happen in this case, which is important, given the controversial nature of its conclusion:
“During the last two decades, the relationship between economic growth and equity returns has been weak across global stock markets. Economic growth has not been a good proxy for dividend-per-share growth. In the majority of the stock markets, issuance has exceeded buybacks and has resulted in a dilution effect. In several markets, however, buybacks have exceeded issuance, resulting in an accretion effect. The main finding of our study is that, whether investors use a dividend model or a total payout model to decompose equity returns, net buybacks explain more than 80% of the cross-sectional dispersion of stock market returns.”
In other words, net buybacks dwarf all other inter-market factors in explaining the returns to various stock markets over the course of the last two decades. If true, it fundamentally shifts our understanding of the impact of stock buybacks. In theory, buybacks are functionally the same as dividends. Yet, this study reveals that buybacks fuel bull markets to an extent that blows away the impact of dividends (or anything else, for that matter).
Upending the conventional wisdom
The results of the study are truly striking. They fundamentally go against the “conventional wisdom” that the primary driver of stock market outperformance is economic growth. According to the data presented in the FAJ, this is not the case at all. In its recent review of the study, The Wall Street Journal highlighted a particularly striking example of this fact:
“Take China, whose economy over the past decade has grown at one of the fastest rates of any major country. China’s real GDP, in U.S. dollars, grew at an 8.0% annualized rate over the 10 years through year-end 2018, versus a 2.1% annualized rate for U.S. GDP. And yet U.S. equities’ annualized return over this decade was more than double that of China’s.”
That is a staggering difference in outcomes, and it is a stark contradiction of what most economists and financial markets experts have been saying for decades. The fact that stock buybacks have been found to have such outsized impact persistently over time and across so many disparate geographies makes it all the more shocking.
Why this matters
Every investor can learn something from this study. It fundamentally alters our understanding of buybacks, both on their own and in comparison to dividend-based cash returns. As companies buy back shares, they add fuel to the market fire, which is a perfect recipe for driving a bull market and encouraging speculative buying. While dividend stocks promise stable payouts over time, those fueled by buybacks are less predictable -- and the payout is realized only by the sale of the security itself.
Seen in this light, the buyback binge in the U.S. over the past few years looks downright dangerous, and that danger is magnified by the new political risks. While Senators Bernie Sanders and Chuck Schumer may be calling for heavy restrictions on buybacks, they lack the political power to actually do anything about them at present. But that does not mean that the time will not come when they do have the power to act. Given the cyclical nature of electoral politics, it is bound to happen sooner or later. When it does, their efforts to improve workers’ conditions could have the unintended consequence of cratering the stock market.
Verdict
Restrictions on buybacks might seem functionally ineffectual on the surface, thanks to the fact that companies could simply switch to dividend payouts. As this FAJ study shows, there is a lot more to it than that.
Investors must be extremely cognizant of the risks lurking under the surface.
Disclosure: No positions.
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