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.”