The resilience of the US Stock Market continued in the 2nd quarter. The economy is still growing, although more signs of a slowdown are appearing. Due to some good posturing, Q1 corporate earnings did “surprise to the upside,”, but corporate earnings growth did slow, as we speculated in our Q1 commentary. The slowdown in earnings is expected to continue as corporation report Q2 earnings. There was also some progress, or at least lack of regress, in the trade war between US and China. At the G20 conference on June 30th, Presidents Trump and Xi agreed to continue disagreeing on friendly terms (without additional tariffs). There’s no trade deal yet but the two fighters have returned to their corners…for now.
The stock market and bond market continue to flash conflicting views on the economy. The stock market points to continued growth; the flattening/inverting yield curve, to a recession. These conflicting views are not necessarily surprising. An inverted yield curve typically occurs months before a recession (it’s happened with no recession as well), while the stock market tends to make huge gains in the lead-up. In other words, the inverted yield curve is usually the guy who shows up early to the party, while the stock market tends to be the one who shows up late and surprised to learn there is a party.
Market sentiment does feel strange right now. Typically, an over-optimistic, sanguine sentiment presides late in the market cycle as the gains make their final push into an economic slowdown. If we are in the stage of the cycle we think we are, this is usually when the money that’s been sitting on the sideline for years is dumped in but there has not been a lot flow into domestic mutual funds and ETFs so far this year. The flow is positive but not by much. Where is the money coming from that’s pushing the market so much higher? A large contributor appears to be Corporate Share repurchase programs.
Corporate Share Repurchases
A share repurchase program is when a company utilizes capital (cash) to purchase their own shares, thus removing shares from circulation. In 2018, corporations – in the S&P 500 – purchased over $800 billion of their own shares. That set a record. In fact, it blew past the old record. According to Goldman Sachs, corporations will set yet another record in 2019. This represents a huge transfer of capital into the markets. If the Goldman Sachs estimate is correct, by the end of 2019, $1.7 trillion dollars will have been pumped into the stock market in two years. Seems like a lot of money, right? It represents almost 7% of the total value of the S&P 500. It’s a lot of money.
Share buy-backs can be an effective tool to return money to shareholders, because they are more tax efficient than dividends. Presuming the seller of the stock had a gain and held the stock in a taxable account, they would owe capital gains tax as opposed to the ordinary income tax they would owe on a dividend. There are also benefits to the remaining shareholders. Reducing the number of outstanding shares increases the percentage ownership of the remaining shareholders. For example, if I own 10 shares of a company that has 100 total shares outstanding, I own 10% of the company (whew…that was hard math). If the company purchases 50 of the outstanding 100 shares but I hold on to my 10, I am now the proud owner of 20% of the company. That should make my shares a whole lot more valuable. What a deal. This is functionally what we see happening in the markets right now. Companies are buying back their shares in record numbers, increasing their shareholders’ relative ownership.
The potential benefits of share buy-backs cannot be argued against, but there are some troubling aspects of the current bonanza (to steal the technical term from the graph above). For starters, what happens to markets when companies reduce their buy-back programs? If the folks over at Goldman Sachs are correct (and why would we ever think otherwise), these repurchases will go on for some time, but they won’t last forever. Data suggests that the capital for these repurchases has come from two main sources. The first is additional debt. In our 2018 Q4 commentary we commented on the US Corporate Debt Binge that has occurred over the last 10 years. A lot of this additional debt appears to have funded share buy-backs. This is somewhat speculation. It is difficult to directly connect that these borrowed dollars went to purchase shares. But when you examine the data of newly issued debt along with data on how capital was deployed, the connection is hard to deny. Jeffrey Gundlach, the currently anointed “Bond King”, claims the two are related. If anyone would have a “feel” for where the capital has come from and where it is going, I think it would be him.
The second source of capital for buy-backs is repatriation of corporate dollars held overseas. Over the last several years, companies have accumulated large accounts overseas as a tax shelter against higher American corporate tax rates. In many cases, companies were borrowing money to finance operations as opposed to bringing it into the US. To encourage the repatriation of this money, the recent tax code revision featured a special rate for repatriated dollars. The idea was for companies to use this money to invest in their business and grow the economy. A lot of it appears to have gone to share buy-backs instead (this does not necessarily mean the money does not go to grow the economy…see Jamie Dimon’s comments below).
What these two sources have in common is they are kind of one-shot deals. Corporations can only access so much debt. While repatriated dollars are a result of earnings, the volume is high because it was built up over years. These one-shot deals have likely been huge contributors to positive market performance the last two years. Markets go up when there are more dollars looking to buy than there are owners looking to sell. In the last two years, corporations appear to have been the overwhelming net buyers. What happens when that money slows down? Will that bring about the turn of this extraordinarily long bull market? Maybe. It will certainly have an effect. How much is hard to tell.
Impaired Corporate Performance?
Another concern to consider is how these share buy-backs will impact corporations’ revenue and earnings going forward. There is always an opportunity cost when deploying capital. In the case of share buy-backs, companies may be missing an opportunity to improve their balance sheet or invest in future growth. CEOs are responsible for making these “capital allocation decisions”…how best to use cash to increase shareholder value. In his most recent annual report, JP Morgan’s Jamie Dimon spent a couple of paragraphs on buy-backs, specifically on what circumstances need to exist for him to consider buying back JP Morgan stock. Here’s what he had to say:
We much prefer to use our capital to grow than to buy back stock. We believe buying back stock should be considered only when either we cannot invest (sometimes as a result of regulatory policies) or we are generating excess capital that we do not expect to use in the next few years. Buybacks should not be done at the expense of investing appropriately in our company. Investing for the future should come first, and at JPMorgan Chase, it does.
However, when you cannot see a clear use for your excess capital over the short term, buying back stock is an important capital tool – as long as you are buying it back at a reasonable price. And when companies buy back stock (which we only do when it is at a price that we think adds value to our remaining shareholders), the capital is redistributed to investors who can put it to good use elsewhere. It does not disappear. We currently have excess capital, but we hope in the future to be able to invest more of it to grow our businesses.
In his view, stock repurchases are almost a measure of last resort. It’s a good tool when there are not enough opportunities to invest excess capital into the growth of the business. But as pointed out above, a lot of companies are not using excess capital. They are financing the purchases with debt. While it provides the immediate satisfaction of increasing the coveted and overly reported Earnings Per Share metric, it does not help the company in the long term. The borrowed money comes at a cost (interest) and will have to eventually be paid back. Debt should be used to finance growth, not engineer accounting. The former can be responsible management; the latter is short-term thinking at its finest.
Also, as Mr. Dimon points out, if a company is going to repurchase shares, they need to do it when they can get a good price, which makes us question the timing of current purchases. To create shareholder value with buy-backs, CEOs should execute the programs when their stock is cheap. In his book, Creating Shareholder Value, Alfred Rappaport gave the opinion that repurchasing fairly priced stock added no value to shareholders, and buying overpriced stock would destroy shareholder value over a long period of time. Opinions may differ as to whether stocks are currently expensive, but I don’t think you will find many people arguing that they are cheap. If they are expensive, then corporations may be participating in the greatest destruction of shareholder value in history.
You might think, hey, these are CEOs, really smart people who would not make such a bad decision. It may be true that they are smart but that does not mean they are good at capital allocation. William N. Thorndike wrote a book, The Outsiders, where he chronicled the decisions of successful CEOs. In the first couple of chapters, he draws from some of Warren Buffet’s writings to make the points that one, in rising through the ranks of business, CEOs may have never had to make capital allocation decisions, and two, CEOs are as subject to “groupthink” as anyone else. With little to no experience with deciding how to invest money and under peer pressure to look like other CEOs, the fact they are overpaying for their stock is not necessarily surprising. In fact, it may be typical. The last time buy-backs were north of $600 billion was in 2007, when the market was reaching its peak. To be fair, this does make some sense. Corporations will have the most amount of cash towards the end of an economic cycle, but they are not forced to use the cash for share repurchases. I would rather have my corporations hang on to their cash, or even pay down debt, until they find good investment opportunities.
Having used up cash and increased leverage, these share buy-backs have likely put corporations in a position where they won’t be able to weather storms or be as prepared to invest when the economy troughs. It puts another strike against the current corporate health and, to us, further emphasizes the need to be mindful of company balance sheets. We will continue to look for opportunities to invest capital at an acceptable level of risk.