August 15, 2019
Record stock buybacks have been a major focus for investors and have even attracted the attention of some politicians and activists, who are advocating for limiting or even banning share repurchases. In this report, J.P. Morgan Research examines the sources and uses of excess cash, the risks that lie ahead and whether the cycle has peaked.
Predominantly an American phenomenon, buybacks are a reflection of the fact that U.S. corporates have substantial amounts of excess cash. They typically take place when companies have leftover cash after they “receive” their profits and make the important decisions of how much to use to fund future capital expenditure (capex) and dividends. In this case, the corporate moves to buy its own stock, reducing the number of outstanding shares and consequently increasing their value. A combination of record profit margins, strong cash flows, strengthened balance sheets, the low cost of debt and increased investor demand has fueled record stock buybacks and corporate activity since the 2008 Global Financial Crisis (GFC).
This year, S&P 500 companies are expected to execute around $800 billion in buybacks, down slightly from around $830 billion in 2018, according to J.P. Morgan projections. So far this year, buyback announcements are running behind last year’s record level, but above the three-year average. In sector terms, financials and tech buyback announcements have led the way, with $151 billion and $124 billion, respectively year-to-date (YTD).
Source: J.P. Morgan U.S. Equity Strategy and Quantitative Research
“The absolute dollar value of buyback announcements reached a record $939 billion in 2018. The cycle has likely now peaked for issuance, buybacks and M&A as the global economy slips slowly into sub-trend growth and valuations are less attractive,” said Joyce Chang, Chair of Global Research at J.P. Morgan.
As well as corporate activity, the market value of tradable U.S. dollar (USD) corporate debt has ballooned to close to $8 trillion – over three times the size it was at the end of 2008. This rapid growth has been driven by attractive borrowing costs, investors looking for alternatives to very low sovereign yields, central bank intervention and less availability of bank funding for some issuers. Some of the cash that has been raised through this strong corporate debt issuance at significantly lower costs has been used to fund share buybacks.
Similarly in Europe, the corporate bond market has tripled to 2.5 trillion euros ($2.8 trillion) since 2008. As in the U.S. corporate bond market, the increase in issuance has gone hand-in-hand with deterioration in the average rating of the market, with the share of BBB-rated bonds in European investment grade growing from 25% to 48%.
U.S. Corporate Debt Credit Quality
The credit quality of the U.S. corporate bond market has shifted, with BBB rated debt now 61% of non-financial debt, up from 49% in 2011. From 2015-2018, over $800B of non-financial high grade corporate bonds were issued to fund M&A. This accounted for 29% of all non-financial bond issuance, contributing to credit rating deterioration.
Corporate buybacks have come under greater scrutiny by politicians and activists alike, highlighting the changing relationship and social contract between businesses, policymakers and the public.
One major critique of buybacks is connected to what the purpose or duty of a publicly-traded company is seen to be, fitting into the larger ideological debate about the benefits and drawbacks of capitalism. On one side, the pro-buyback camp follows the theory of “shareholder primacy,” which argues that a firm’s executives and directors should maximize “shareholder value” as measured by share price. On the other side, many of the anti-buyback camp’s critiques stem from the view that companies have an obligation not only to their shareholders, but also to other stakeholders such as employees or even society as a whole.
Since the passage of the 2017 Tax Cuts and Jobs Act, a number of politicians have released proposals to curb stock repurchases, arguing that corporates have used excess capital to buy back more stock instead of investing in their businesses.
“We believe limiting buybacks is not the best way to achieve social aims, especially since buybacks serve legitimate business purposes. They are an important part of the capital allocation process and can increase long-term shareholder value,” said Chang.
“While some of the corporate governance issues around buybacks are worthy of scrutiny, we believe there are more direct ways to address these issues than by restricting buybacks altogether, such as changing how executive compensation is calculated or how buybacks are conducted, rather than by prohibiting buybacks altogether,” Chang added.
Although buybacks and dividends are both ways to return capital to shareholders, the former has fallen under greater scrutiny in part because buybacks mechanically increase earnings per share (EPS) (by reducing the number of shares outstanding), while dividends do not affect EPS. However, there are many other reasons why companies and investors may prefer buybacks over dividends:
Why Do Companies Prefer Buybacks?
Critics of buybacks have argued they reduce long-term shareholder value because the money used to fund buybacks could instead be used on profitable investments, such as research and development (R&D) and increasing worker productivity. But companies actually increased investment in capital expenditure (capex) by 16% (or $99 billion) and boosted dividends by 9% ($38 billion) during 2018, when the absolute dollar value of buyback announcements reached a record $939 billion, according to J.P. Morgan data. U.S. corporate R&D spending as a percentage of GDP has also been rising over the past decade and number of patents awarded (a measure of R&D output prowess) has tripled over the past 25 years.
“On the whole, we feel the concerns about the purported long-term harms of buybacks are overblown. When capital is returned to shareholders via buybacks, investors reinvest this capital elsewhere; they do not simply sit on the cash. Corporate buybacks have returned $5 trillion to shareholders since 2009,” said Head of Long-term Strategy at J.P. Morgan, Jan Loeys.
In addition, if companies truly were unwisely diverting money from profitable investments in order to do buybacks, then they would likely underperform over the long term, but this is not the case. Stocks of companies that buy back their shares tend to outperform both short and long term according to J.P. Morgan and independent research.
U.S. and European companies that bought back over 5% of their shares over a rolling 12-month period outperformed the overall market by more than 4% over the last 25 and 20 years, respectively, according to J.P. Morgan findings. Likewise in Japan, the data showed high-buyback companies outperformed over the past 13 years, but by a significantly smaller margin.
“While it is true that stock buybacks have reached a record level in absolute terms—nearly $1 trillion—announced in 2018, we point out that the level of buybacks is running at just below the average pace of the past 15 years given the structural shifts that have transformed the corporate market since the 2008 GFC. Accounting for the tripling in the size of the market capitalization, the 2019 annualized pace of buybacks represents only 3% of the S&P 500,” added Loeys.
Buybacks have remained a key theme in the U.S. through the current cycle. While announcements are trailing the record of $939 billion in 2018, they are above the 3-year average. Last year technology ($350 billion) and financials ($194 billion) companies alone announced as much as all S&P 500 companies in 2017 (around $550 billion).
Source: J.P. Morgan U.S. Equity Strategy and Quantitative Research
“Technology companies continue to aggressively buy back shares given stronger growth, higher margins, lower capital requirements, and still high overseas cash balance. Looking beyond 2019, the outlook for buybacks will depend heavily on whether or not trade conflicts are resolved, as well as the broader health of the U.S. economy,” said Head of U.S. Equity Strategy and Global Quantitative Research, Dubravko Lakos-Bujas.
Outside of the U.S., buyback activity has been more limited, which explains some of the outperformance of U.S. stock markets in recent years. In Europe, corporates have been allocating a higher proportion of cash to buying back their stock, but buybacks are still a much weaker force there compared to the U.S. This can mostly be put down to an investor preference for dividends and a focus on deleveraging in Europe, with financials and staples leading the way.
“Despite the lower importance of buybacks in the region, we find that European companies that are doing buybacks have strongly outperformed the broader market these last few years,” said Head of Global Equity Strategy at J.P. Morgan, Mislav Matejka.
In emerging markets (EM), buyback activity has also been low, likely reflecting a preference to deploy capital in growth opportunities and/or less overall free cash flow. The total value of EM shares repurchased has grown from $6 billion in 2000 to $34 billion in 2018, and the number of buybacks rose from 100 to 230.
China’s A-share market is experiencing a strong upward trend in share repurchases. Since 2018, buybacks hit a record $7.3 billion in 2018 and have climbed to around $10.3 billion year-to-date, compared to $1.2 billion in 2017. This explosion in share buybacks has been supported by a relaxation in policy rules, coinciding with the decline in outward investment over the past two years.
In contrast to Europe and EM, buybacks in Japan have reached record levels. At the end of 2018 the amount of share buybacks executed reached 5.7 trillion yen ($52.5 billion) exceeding the 5.4 trillion yen recorded for 2015. So far this year, 4 trillion yen in buybacks have already been announced.
"We see three factors driving this rise in share buybacks in Japan. The first is increased corporate awareness of shareholder returns and capital efficiency, amid a string of corporate governance reforms. Secondly, Japanese stocks were weak in 2018 and thirdly there has been improvement in corporate finances under a generally favorable earnings environment for the last 5 or 6 years,” said Ryota Sakagami, Head of Japan Equity Strategy.
Buybacks in numbers
In Europe, buybacks hit around $150 billion in 2018, with financials leading the way, accounting for around $48 billion of that figure.
The total value of EM shares repurchased has grown from $6 billion in 2000 to $34 billion in 2018, and the number of buybacks rose from 100 to 230.
In the U.S., there has been some moderation in share repurchases given rising equity values. Buyback executions by S&P 500 companies are expected to decline slightly to around $800 billion in 2019, from $830 billion in 2018.
Source: J.P. Morgan
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