Apple is among those doing so, but rather than depleting their cash reserves to buy back shares, companies such as the iPhone maker are increasingly borrowing to do so, taking advantage of the current low interest rate environment to change their capital structure.
“A lot of the cash pile is located outside the US,” Ferguson explains. “There would be a tax repatriation penalty for bringing it back. The cost of borrowing is so low companies can keep the cash on their balance sheets outside the US to avoid that tax penalty, but borrow at low rates in the US to fund buybacks.”
The number of fund managers suggesting the US stock market is already fairly if not over-priced seems to be increasing by the day and with leverage levels also increasing in order to fuel that rise in share prices, the critical question becomes how sustainable the current level of buybacks is.
THE ANTITHESIS OF SOUND INVESTMENT
Corporates are notoriously bad at timing their buybacks and tend to buy the most shares when their stock is expensive and less when it is cheap, which is the very antithesis of a sound investment strategy. Data from S&P Dow Jones Indices, for example, shows the dollar value of buybacks peaked in the third quarter of 2007, which coincided with the peak in the market value of the S&P 500. Both values fell sharply, bottoming out in the second quarter of 2009, before restarting a rapid ascent, which saw the dollar value of the S&P 500 peak at over $18trn at the end of last year.
Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, says: “At the end of Q1 2015, buybacks were reporting in the $148bn area, up from $132.6bn of Q4 2014, but still shy of the $159.3bn of Q1 2014 or the record $172.0bn of Q3 2007. Share Count Reduction continued for the fifth quarter, as 20% of the index reduced the year-over-year diluted share count by at least 4%, therefore increasing their EPS by at least 4%.
“We will soon be getting away from our addiction to low interest rates,” he adds, “but the addiction to buybacks still appears to be growing.”
CAN THE BINGE CONTINUE?
There are strong signs the buyback binge has some way to run. S&P data shows cash holdings have increased much faster than buybacks. At their peak before the last crisis, cash represented around four-times buybacks in dollar terms. In 2014, cash was 11-times buybacks and the strong community of activist investors bent on getting companies, such as Apple, to pay that through to investors means the pressure to engage in buybacks will continue.
As Ferguson says: “The US is seeing an increasing amount of activist activity as they are drawn to the cash sitting on balance sheets. Management boards can either wait for someone to do it to them or they can control how they deploy their capital while maintaining their control.
“US companies are very good at generating profits and have a high conversion rate into cash,” he says. “The S&P 500 generates a 5% free cash flow yield annually so it is incredibly cash generative.”
But the cash picture alone masks the building of leverage back to record levels, which leaves the market more sensitive to interest rate and wider market shocks.
WHAT IT ALL MEANS FOR INVESTORS
For those who believe markets will continue to grow in a benign manner without the risk of significant shocks to the downside, the buyback binge presents an opportunity for investors to ride a rising trend.
As long as corporate support remains strong in the market, investors can look forward to outperformance by investing in companies engaged in buyback programmes. As Lake says: “Share prices tend to perform their best in the 12 months following a buyback.”
With so many US companies engaged in doing so, the spoils could be significant given the huge and increasing mountains of cash that remain available for deployment. JLT’s Nazarova-Doyle, for one, believes: “at the moment the environment seems good for it.”
However, it is important not to overlook the poor track record corporates have at timing buybacks and the dangers presented by leverage building in the system to fund the change in capital structure. While investors might not mind leverage when markets are on the up, as they turn south the more leveraged a company is, the quicker the market will head for the door and shareholders may find the buybacks they thought were their friends quickly turn into a formidable foe.
Given the global nature of many of the companies engaging in buybacks, few investors on this side of the Atlantic will be immune if the buyback bubble does burst.
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