This is my reading of an excellent paper by S&P Global, “Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market” by Liyu Zeng and Priscilla Luk, March 2020.

Over the past 20 years (up to end of 2019), the S&P 500 Buyback Index had outperformed the S&P 500 in 16 out of 20 years, or about 5.5% per year. YTD, it has underperformed, though, by about 14%! With that it, has managed to erase the last 10 years of outperformance! 

We had similar underperformance of the buyback index in the early stages of the last financial crisis, in 2007; while in 2009, the S&P 500 Buyback Index had a significant excess return. Make your own conclusions where we are in this cycle.

Reality is that “buybacks tend to follow the economic cycle with increased or decreased repurchase activities in up or down markets while dividend payouts are normally more stable over time, the S&P 500 Dividend Yield portfolio tends to outperform in down markets, while the S&P 500 Buyback Index may capture more upside momentum during bull markets.“

Almost all of tech, financial sector and consumer discretionary companies engage in share buybacks. Less than 50% of utilities do (but they all pay dividends). As share buybacks tend to congregate in cyclical rather than defensive sectors, the buyback index tends to underperform during recessions (this year).

Since 1997, the total amount of buybacks has exceeded the cash dividends paid by U.S. firms. The proportion of dividend-paying companies decreased to 43% in 2018 from 78% in 1980, while the proportion of companies with share buybacks increased to 53% from 28%. 

Compare to other developed markets. Despite an increase of share repurchases in Europe and Asia, as a % of all companies, buybacks still stand at about half that in the US. On the other hand, fewer Canadian companies engaged in share buybacks during that period. 

For the S&P 500 Index, over the last 20 years, 2/3 of the total return has come from capital gains and only 1/3 from dividends. Before the mid-1980s, when buybacks became dominant, the opposite was true. Buybacks have been instrumental in driving equity returns since the mid-1980s.

Apple is up more than 70% this year; Microsoft – 50%. Together they have contributed almost 40% to the more than 30% rise in the Nasdaq.

Facebook, Google and Amazon, the other heavy weights in the index, have together contributed about 19% to this year’s performance.

Just five companies have contributed almost 60% to this year’s Nasdaq returns!

Apple and Microsoft together have bought back almost $85Bn of their own shares this year. Amazon does not buy back its shares (yet). Google started in 2015 and has bought back $8Bn this year. Facebook started buying back its shares last year and has bought back about $13Bn this year.

Intel, Comcast, Nvidia, Costco, Charter Communications bring up the top 10 with a combined share buyback of around $20bn. Costco, Charter Communications and, to a certain extent, Nvidia, are actually, good examples of Yardeni’s claim that companies mostly buy back shares to avoid dilution. Sadly, that is not the case for the heavy hitters in the list, the ones doing most of the buybacks, and thus the ones with a disproportionate influence on index performance. For example, just among those five, Intel and Comcast have done 3/4 of the combined buybacks.

There is a big difference when it comes to Apple and Microsoft, however.

Since 2007 Apple has outperformed Microsoft in both Revenue growth (former’s increased 10x, latter’s – about 2.5x) and EPS growth (20x increase vs. 3.5x). In 2007 Apple’s revenue was about half of Microsoft’s. In 2010 they were the same. Today Apple’s revenue is more than 2.5x bigger than Microsoft’s, however it topped in Q3’2018, while Microsoft’s is still growing.

Apple only started paying dividend in 2010 and buying back its stock in 2011. Since then, both have spent about 25% of their top-line revenues, on average, on shareholders payouts. However, Microsoft spends considerably more on R&D as a % of revenue than Apple.

Apple managed to reduce its share count by almost 30% since 2012. Microsoft reduced its share count by a ‘mere’ 22% since 2007. And it shows. Apple’s share price has massively outperformed Microsoft’s since 2007. Of course, there are other factors in place (the IPhone came in 2007) and maybe it is just a coincidence that the out-performance started in 2010, when Apple began giving cash back to shareholders!

Bottom line: Make sure you have at least AAPL and MSFT share price on your screens all the time into year end.

Home Depot cuts its 2019 forecast after sales miss; shares drop the most since 2008.

Since 2007, Home Depot’s top-line revenue has increased by 37%, while its EPS has increased by 249%, almost 7x more.

Since 2007, Home Depot has bought $72Bn shares back, one of the largest share buyback programs out there, cutting its share count in the process by almost half; yet its dividend payments increased by more than 3x.

Emphasis on the fact that Home Depot topped analysts’ expectations for earnings but sales fell short. Which is exactly the story of our times: Easier to push up EPS through the share count (buybacks) than through top-line revenue growth. Management also gets paid on EPS, not revenue.

And the cherry on the cake: Home Depot’s share price has increased by more than 700% since the end of 2007; the S&P Index has increased by about 111% since then.

One would have thought that after so many years of Home Depot using the same technique to ‘score a home run’, investors would have understood the tactic and re-priced its valuation.

The idea about this post came after listening to Ben Hunt’s and Ed Yardeni’s recent Ritholz Wealth Management podcasts. While, in general, I do agree with the conclusion Ben reaches, I thought looking at just two individual companies’ share buyback programs, as he did in two separate posts, is perhaps a bit too narrow. At the same time, I was doubtful whether Yardeni’s approach of going to the opposite extreme of looking at all S&P 500 companies and taking the average is equally that ‘practical’.

Ed Yardeni is a top strategist but his claim in “Exposing the big lie about stock buybacks”  that the majority (2/3) of US stock buybacks go to cover employee stock issuance, even if true on an aggregate level, does not change the fact that buybacks are possibly the main driver of US stock out-performance.

According to Yardeni, some of the widely followed data shows the wrong number for stock buybacks. And the Fed seems to agree that its own Z1 Flow of Funds does not fully include issuance of shares to employees:

“The current source for equity issuance data in the Financial Accounts of the United States does not fully incorporate issuance to employees by public corporations. Staff is exploring how best to reflect such issuance activity in future releases.”

Emphasis on fully. What does this mean? Look at p.68, table F.223 of the latest Flow of Funds data. So, line 2 (‘Nonfinancial corporate business’) does not include ESOPs (and other equity compensation plans)? I don’t think that changes the demand-supply dynamics. Share grants are different from IPOs and buybacks as they are a non-cash flow item, as in the former there is no exchange of cash at issuance and the effect on the supply of shares happens only when those are sold by the employees in the secondary market. They are a balance sheet item. So mot likely, they will be registered either in line 16 (‘Household sector’) or in line 31 (‘Broker and dealers’) at the point of sale. 

In any case, in the Flow of Funds data, ‘Net Issue‘ and ‘Net Purchases‘ have to balance, if we start tinkering with the net issuance (line 2), as in, assume that actually US corporates net bought back fewer shares to account for the ESOP (and other equity compensation programs), then we have to also change something on the net purchases side (line 15 and below). My guess is that ESOPs are incorporated in the Flow of Funds data but not in the net issuance section (with a positive sign), rather in the net purchases section (negative sign). I think this is the more likely scenario in what the Fed official meant as “not fully incorporating ESOP” in that data.

I could be wrong on this, so looking forward to some clarity from the Fed in the future publications of the Flow of Funds data.

I have no reason to doubt indeed that on average for all the companies in the S&P 500, 2/3 of share buyback activity goes towards avoiding dilution from share issuance on the back of employee compensation plans. However, this is not true for the largest corporate share buybacks programs in terms of dollar amounts conversion. And because of their market weight, this is where the big impact from buybacks on the S&P 500 comes from (on average, the price change of these companies’ share price is double that of the S&P 500 in the last 8 years).

If we take the 20 largest share buybacks programs and look at the same period 2011-2018 which also Yardeni data covers, employee stock compensation is only about 14% of the value of the corporate share buybacks. The ratios vary from company to company but just to give you an example, for Apple, which has, by far, the largest share repurchase program of all companies in the US, employee stock compensation is on average about 11% of total buybacks. The banks have the largest ratio, at around 35%, while Boeing and Visa have the lowest, around 4%.

Those large share buyback programs have reduced the companies share count by about 18% on average between 2011 – 2018. In some of the larger buybacks, like Apple, Pfizer etc., the share count is reduced by almost 25%. So, even if indeed some of the share buyback activity is on the back of employee compensation, there is still substantial reduction in the share count which should have an effect on share prices and on performance indicators per share.

ESOPs are actually not that prevalent in US businesses. In fact, only about 10% of the private workforce is involved in such programs and only about 10% of the publicly traded companies have them. Public companies, however, have other equity compensation programs but they are mostly geared to senior management. There are three kinds of equity awards that public companies give: restricted shares, share options and performance shares.

Share options had been the original and the most popular form of executive compensation until the mid-2000s or so. Their use was limited in the 1960-1970s, however, as the stock market languished and went nowhere (which is when companies started giving out restricted shares, which, even though they vest, they do not require either any upward movement of the share prices to ‘make money’ – as options do, or beating any performance targets – as performance shares do).

However, by the late 1990s, with the stock market rising substantially on the back of the financialization of the US economy which started in the 1980s with the doctrine of shareholder primacy and the accompanying surge of corporate share buybacks (SEC Rule 10B-18), the popularity of stock options surged to 75% of all executive compensation. By the mid-2000s, though, three things happened which affected adversely the use of stock options in executive compensation programs: 1) in 2006 the accounting rules changed, resulting in charge against earnings for the grant of options; 2) during the crisis of 2008, stock markets fell substantially; 3) The Dodd-Frank Act of 2010 now requires a say-on-pay vote. As a result, organizations such as Institutional Shareholder Services, now have a much greater influence over executive pay. Therefore, performance shares have become the dominant source of executive compensation.

There are two points I want to make here. First, the concern over exuberant executive pay is not something new – regulators have been looking into it since at least the 2000s. Second, because the performance targets are tied to companies’ EPS, the changes made to the executive compensation plans, unfortunately, fall short of their target: senior management can legally find a loophole to still continue to disproportionately increase their compensation. What do I mean ‘disproportionately’? I mean relative to other employees’ compensation and to companies’ top line growth.

Which brings me to a second claim made by Yardeni, namely that S&P 500 companies’ EPS growth is only about 1% lower than their total earnings growth. Again, I have no reason to doubt that, as a whole, this is correct: on average across all the S&P500 companies, there may not be much ‘smoothing out’ of EPS through share buybacks . But looking at the largest share buybacks programs, that’s not the case.

Of those, on average over the 2011-2018 period, top line net operational income growth is about half of EPS’s growth. What I found is that while top line income growth is somewhat similar to the average of the whole S&P 500 index (11.1% vs 8.1%), EPS growth in the largest share buyback companies was much higher.

Again, the numbers vary. For some (Microsoft, Nike), actually, average top-line growth is slightly higher than EPS growth. On the other spectrum, companies like Pfizer and Merck have had much smaller top line growth rates than EPS ones. Apple, having the largest share buyback program, has a more respectable 23% average annual top line operational income growth rate vs 27% EPS growth rate. But still very far from the average for the S&P 500 index company.

In fact, for majority of the companies in that sample, their revenues had peaked already some time ago. That did not stop companies continuing with their share buyback programs. In fact, some like Apple, Cisco, Amgen, BAML, Merck, Pfizer have substantially increased their spend on share buybacks thereafter.

Given the above, it is not unreasonable to assume that indeed senior management in these companies is ‘wrongly’ incentivized to authorize more buybacks despite lackluster top-line operational performance in order to benefit from the obviously better EPS performance.

But it is not all doom and gloom when it comes to share buybacks. Employment has risen on average by 26% over that period for those companies. However, that is really concentrated in a few big companies like Apple, Microsoft and Nike (for example, Apple has doubled its employment between 2001-2018). A lot of companies, the industrials (Pepsico, Merck, Pfizer, Texas Instruments) and the banks (JPM, BAML) have actually marginally reduced employment.

Finally, while it is reasonable to suppose that a lot of the increased activity in buybacks is linked to senior executives’ compensation packages, it is a lot more difficult to make the claim that they happen at the expense of R&D. For example, comparing Apple to Microsoft – massive difference when it comes to R&D spending vs buybacks. While Apple has spent a lot less on R&D vs buybacks in the last 8 years (in fact $175Bn less!), Microsoft has spent a lot more ($19Bn). And while Apple spends just about 3% of its revenue on R&D, Microsoft spends about 13%.

There is a divergence among the industrialists as well, with Texas Instruments, Boeing and Amgen spending substantially more on buybacks relative to R&D, while Pfizer, Merck and Cisco have spent substantially more on R&D than on buybacks.

What’s the right way to analyse US share buybacks? I don’t think there is one right way. Ben Hunt has done great investigative work looking at a couple of the large corporate share buybacks. Ed Yardeni has done the same looking at the whole S&P 500 index. I have taken the middle road by looking at the 20 or so largest share buybacks. Probably each one of these three approaches is prone to some selection bias geared to the conclusions one may want to reach!?

From being a niche discussion and research topic when I first started looking at it in 2015 to being now in the popular media on a daily basis, share buybacks do deserve this attention because they could be potentially affecting things like income and wealth inequality, corporate investment, employment, productivity, economic growth, etc. So, it is only good if more and more people look at the the numbers to try to figure what exactly is going on.

I don’t think the stock market bulls appreciate the wave of supply that may hit the market in 2019. I know we got used to billions of dollars of share buybacks on the demand side while not paying that much attention to the supply side. Yet, IPOs in the last few years have been quietly building up. In fact, if the experts are right, 2019 could beat the IPO record issuance reached before the dotcom bust.

According to Renaissance Capital, the total value of private companies that are planning to go public in 2019 is $697Bn. They estimate that if just 15% of that value exits at IPO, that would amount to over $100Bn which would be more than the record for IPOs set in 2000.

If companies manage to get their valuations just from tech names, there is a minimum of $200bn of value in the pipeline (Lyft, Uber, AirBnb, Pinterest, Slack, Postmates). Using the 15% benchmark, see above, that would make tech IPO size in 2019 somewhat similar to 2018 when the tech sector raised $32Bn in IPOs. But the $200Bn amount is on the conservative side. That would still make the tech sector the largest one in terms of IPO issuance.

How will that play out? Will there be enough demand to offset this supply? With fewer individual retail accounts and fewer active managers than in 2000, how would passive investors react to this?

On top of that, we have the threat of more regulation, especially on the tech sector, but also on the general market with the spectre of a ban on share buybacks looming on the horizon.

Just looking at the supply – demand dynamics, it feels like we do not even need to bother with the ‘subjective fact’ of excessively high valuations and recent earnings downgrades to make a good bear case for US stocks. But I can already foresee what the bulls would say, “If you discount the data by market cap, the extreme IPO number does not look that bad”. I guess, the jury on this is still out.

There are two things we can say for sure about share buybacks:

1) based purely on equity flows, they have dominated equity markets since at least 2000

2) based purely on the reduction of share count, and assuming no increase in leverage, as is indeed the case for most of the largest share buybacks, they push up the price of shares

The verdict is out on whether they contribute to lower capital spending, and indirectly cause stagnant employment and wages. Given the supremacy of the shareholder primacy doctrine, I would be surprised if the latter does not hold (that is the whole point, in fact, even though, if every company targets lower employment costs, the cumulative effect on the economy would be lower aggregate demand, thus indirectly lower long-term company profitability), while it would be irresponsible if the former does, given that this ultimately cuts long-term profitability prospects.

Given the record amount of investor equity outflows, the record amount of company share buybacks and the near vertical rally in US equities since the beginning of the year, we can finally put to rest the hypothesis that it is share buybacks that drive primarily equity performance. This is indeed the conclusion that sell-side analysts have come to recently (see Citi, JPM, GS), based on equity flows, notwithstanding that when I was at HSBC, we came to the same conclusion three years ago. It stands to reason then that as S&P companies enter their blackout period en-masse starting next week and going into the middle of April, we should expect equities to lose some ground.

Things are a bit more nuanced though. The biggest mistake people make when analysing buybacks is that they look at the whole market and use averages. You want to understand the effect of buybacks, look at the companies doing the buybacks.

• Only 13% of publicly listed companies engage in share buybacks.
• Of those, the largest 20 companies constitute more than 50% of all buybacks.
• Of those Apple alone constitutes about ¼ of the total amount bought back.

The high concentration of buybacks among very few of the largest US companies guarantees their outsize effect on US equity indices performance while at the same time plays down their effect on equity fundamentals when looking at indices averages.

One unifying feature of the companies doing share buybacks is that their share count ends up substantially reduced. This is in stark contrast to the general market where share count is more or less flat to slightly down over the last 20 years or so. Over the last 5 years, the combined share count of the 20 largest share-buyback companies decreased by 11%. But there are wide variances amongst them. The biggest buybacks naturally reduce the most the share count. For example, Apple’s share count decreased by 23% and Boeing’s (5^th largest) decreased by 24%.

There are two exceptions. Broadcom authorized $12Bn in buybacks in 2018 but over the last 5 years its share count has actually risen by 71%. And Micron Technology had a $10Bn buyback programme in 2018 but its share count has increased by 16% over the last 5 years.

Another unifying feature of the companies doing share buybacks is that their share prices tend to rise over time. The causation is a lot more difficult to prove given that over the last 5 years the general stock market is also up. But still, the average share rise of those 20 companies is almost double the rise in the S&P Index over that period.

And again, there are two exceptions. Qualcomm share price has decreased by 28% over the last 5 years despite its share count down by 17%. And ConocoPhillips lost 4% of its value while its share count went down by 5% over the period.

Do share buybacks ‘cook’ the books. Difficult to say using averages even on those 20 companies. Indeed, of those 20, on average top line growth is smaller than bottom line growth but is this from reduced share count or as a result of expanding profit margins due to cost cutting, for example? One has to dig deeper into the numbers on individual basis. Apple’s and Cisco’s Revenue growth is about half its EPS growth; Intel’s, Texas Instruments’, Amgen’s equivalent is between 3x and 5x smaller; yet Qualcomm’s, United Health’s and Wells Fargo’s Revenue is about 1.5x bigger than its EPS growth rate. And still others, like PepsiCo, Pfizer and Nike, have a negative Revenue growth rate but a positive EPS one. Finally, both ConocoPhillips and Merck have negative growth rate for both top-and bottom-line numbers.

Do share buybacks happen at the expense of capital investment? Again, difficult to judge even from these 20 companies without digging into debt, FCF etc. or other specifics. On average, capital spending growth over the last 5 years is in line with Revenue growth and below EPS. But there are, of course, outliers. Qualcomm, 3M, Adobe and Cisco have a negative capital spending growth rate despite positive Revenue and ESP growth rates. Oracle and Texas Instruments have double digit capital spending growth rates despite small single digit Revenue growth rates.

A few prominent people in the markets have written in support of buybacks and playing down their role in analysing US equity performance, but having looked at the numbers again from the bottom up, I cannot help but disagree with their conclusion.