Swedroe: Exploring Buybacks’ Impacts

As the director of research for Buckingham Strategic Wealth and the BAM Alliance, I’ve been getting questions about the effect of the highly publicized recent surge in stock buybacks, specifically: Are the buybacks driving up prices leading to overvaluation?

To start to answer that question, we can look at the performance of the SPDR S&P 500 Buyback ETF (SPYB). The index comprises the top 100 companies in the S&P 500 with the highest buyback ratio in the last 12 months.

Using Morningstar data, in 2017, SPYB returned 21.0%, underperforming the Vanguard S&P 500 ETF (VOO), which returned 21.8%. And through August 30 of this year, SPYB has returned 5.5% while VOO has returned 6.4%.

In other words, the stocks with the highest amount of buybacks have underperformed. Having examined the evidence that refutes the claim, let’s turn to examining the economic theory on buybacks.

Considering The Theory

Franco Modigliani and Merton Miller, both Nobel Prize-winning economists, are perhaps most famous for their proposition that, in the absence of taxes (and a few other assumptions, such as efficient markets), it does not matter what capital structure a company employs to finance its operations.

They theorized the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends. Of course, in the real world, companies and investors face taxes, which gives corporations an incentive to use leverage (due to tax deductibility of interest), at least to an optimal level.

The Modigliani/Miller theorem is often called the “capital structure irrelevance principle.” In other words, without considering taxes, whether a company uses cash to pay a dividend, repurchase shares or make an investment, its cost of capital (and thus the return to shareholders, the flip side of the cost of capital) is unchanged. This has been the operating model in finance for more than 50 years.

In a December 2017 paper, “The Premature Demonization of Stock Repurchases,” AQR Capital Management’s Clifford Asness, Todd Hazelkorn and Scott Richardson address four myths related to aggregate share repurchase activity. They show that:

• While total dollars now spent to repurchase shares is high relative to history, companies are not “self-liquidating” as some claim. Instead, repurchases have been largely financed by debt issuance. In fact, when scaled by market capitalization, the upward trend in share repurchases over the last five years disappears.
• There is no obvious link between aggregate share repurchase activity and a decline in aggregate investment activity. First, net equity issuance over the last five years has been positive. Second, share buybacks have been funded by an increase in historically cheap (and tax-subsidized) debt, not a decrease in investment. In other words, share buybacks have been a form of recapitalization and a shift from equity to debt financing (which is logical in light of today’s historically low real interest rates). Third, there’s no apparent negative relationship between normalized investment and share repurchase activity. In fact, the two variables have been positively correlated of late, as both investment and share repurchases have increased since the end of the global financial crisis.
• Aggregate repurchase activity is not, and cannot be, responsible for strong equity market returns over the last eight years—share repurchases are not “propping up the market.”
• Aggregate repurchase activity is not associated with mechanical or automatic earnings-per-share (EPS) growth as is often claimed. Specifically, the claim is that by repurchasing shares a company decreases its share count and so mechanically increases its earnings per share. But this ignores the fact that decreased cash can mean lower earnings, due either to less interest earned on that cash (or greater interest expense if debt is used to finance repurchases) or the loss of returns from other uses for it. In addition, the assertion that any increase in EPS leads to a commensurate increase in share price reflects a naïve understanding of basic corporate finance (e.g., Modigliani/Miller). Any increase in leverage that increases EPS increases risk at the same time, with the net effect being a wash on firm equity value. Empirically, no clear link exists between share repurchases and EPS growth. EPS growth rates for firms that do not repurchase shares are approximately 1% higher than EPS growth rates for firms that do repurchase shares.

It’s also important to remember that, as Asness, Hazelkorn and Richardson note, “Investors’ proceeds from share repurchases do not simply disappear. Rather, these funds are received by equity investors, who can (and do) allocate the proceeds elsewhere, thereby funding other investments. In fact, the redirection of available capital to the best available investment opportunities is the very purpose of a well-functioning capital market.”

Additional Points

Furthermore, there are logical reasons for investors to have a favorable view of share buyback programs. For example, repurchases might signal that management believes shares are undervalued. (If management believed they were overvalued, it would instead choose to pay a dividend, or it could choose to issue more shares.) In addition, buying back shares is inconsistent with the idea that management is forgoing attractive investment opportunities.

What’s more, because interest payments are tax-deductible, debt-financed repurchases can be viewed as good news due to the resulting lower tax burden. Another benefit is that share buybacks reduce agency risk—that is, management engaging in “empire-building” acquisitions (the same argument made by those who have a preference for dividends).

Asness, Hazelkorn and Richardson note these factors help explain findings in academic research that “the announcement impact on returns of share repurchases is between 1% and 2% on average repurchases”—a small, but positive, effect. On the other hand, it’s important to remember that stock buybacks increase the financial leverage of the firm, making it a riskier investment, which could lead to a lower price-to-earnings ratio, which is why Modigliani and Miller hypothesized that capital structure doesn’t matter.

Another important point is that taxable investors should have a preference for buybacks over dividends—a point that investors with a preference for dividends often ignore. The reason is that, unlike dividends, where taxes are paid on the full distribution amount when shares are sold, taxes are due only on the portion of the sale representing a gain. And if the investor does not need the cash flow, the buyback avoids the payment of any tax (at least until the shares are sold).

Asness, Hazelkorn and Richardson concluded: “Aggregate share repurchase activity has not been at historical highs when measured properly, and when netted against debt issuance is almost a non-event, does not mechanically create earnings (EPS) growth, does not stifle aggregate investment activity, and has not been the primary cause for recent stock market strength. These myths should be discarded.”

The bottom line is that neither theory nor the evidence on returns supports the idea that buybacks are either inflating stock prices or driving the bull market. For those interested in understanding the math of how buybacks can impact metrics such as price-to-earnings, price-to-dividend and enterprise value-to EBITDA (earnings before interest, taxes, depreciation and amortization), I recommend this article by Jon Seed at AlphaArchitect.com: Buybacks: Why They Don’t Matter, Why They Do, and Why You Should Care Yet Still Relax.

Another Effect Of Buybacks

Before closing, we need to discuss one more important point—how buybacks impact the way in which investors receive returns. Philip Straehl and Roger Ibbotson contribute to the literature with their study “The Long-Run Drivers of Stock Returns: Total Payouts and the Real Economy,” which appeared in the third quarter 2017 issue of CFA Institute’s Financial Analysts Journal.

The authors observe that “buybacks have a fundamentally different impact on the return generation process than dividends do. Although payouts via dividends increase the income return, buybacks increase the price return (per share) because a buy-and-hold investor’s share in a company is increased.”

They then explain that traditional return models are often wrongly applied in practice because investors tend to combine current dividend yields with historical per-share growth rates when forecasting expected returns.

This can lead to underestimating forward-looking per-share growth because buybacks increase a buy-and-hold investor’s proportion in the company over time. In other words, buybacks increase per-share growth. Examining data from 1871 through 2014, Straehl and Ibbotson found:

• Total payouts per share (adjusted for the share decrease from buybacks) grow in line with economic productivity. Aggregate total payouts grow in line with aggregate GDP—total payouts participate in the growth of the real economy. From 1901 through 2014, aggregate total payouts and GDP grew at roughly the same annualized rate: 3.27% and 3.36%, respectively.
• By ignoring buybacks, the dividend discount model (DDM) significantly underestimates the forward-looking equity return when the current yield is combined with historical growth.
• For the period 1970 through 2014, including share buybacks along with dividends in the payout terms dramatically raises the payout yield from 3.0% (dividend yield) to 4.3% (total yield), highlighting the important role buybacks have played in returning cash to shareholders in recent decades.
• The cyclically adjusted total yield is at least as predictive of changes in forward-looking expected returns as the cyclically adjusted price-to-earnings (CAPE 10) ratio.

The authors concluded: “The total payout model represents a viable alternative to such traditional supply models of stock returns as the DDM, providing a framework for deriving macroconsistent forecasts of long-run stock returns as well as superior forecasts of short-term expected returns.”

When they examined data as of the end of 2014, Straehl and Ibbotson found that while the DDM provided a forecast for expected real stock returns of 3.63%, the total payout model provided an expected real return forecast of 5.11%, a difference of almost 1.5 percentage points.

Summarizing, the structural shift in payout policies that occurred in the 1980s clearly has impacted how investors receive returns. Yet this shift has tended to be ignored by those using the DDM to forecast expected returns. Straehl and Ibbotson showed that when estimating future returns, investors should not ignore this increasingly important source of shareholder return.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.