This Is What The Slow-Motion LBO Of The Stock Market Looks Like

When it comes to stock buybacks – an increasingly politically charged topic – 2018 has already been a historic year: as we first reported three months ago, as a result of Trump tax reform which made offshore cash repatriation far more economical, corporations would use much of this redomiciled cash to buyback $650 billion of their own stock in 2018, an all time high (for an extended analysis of the market and political implications of record cash flows, see ““Day Of Reckoning” Nears As Goldman Projects A Record $650BN In Stock Buybacks“)

A few weeks later, JPM followed up with its own stock buyback analysis, calculating that no less than $840 billion in stock would be repurchased courtesy of the new tax law, a staggering number as shown in the chart below.

Fast forward to last week, when the WSJ expounded on the stock buyback tsunami, reporting that “U.S. companies are buying back their shares at a record pace, providing support for the stock market when many investors have rushed for the exits.”

S&P 500 companies that have reported earnings for the first three months of 2018 bought $158 billion of their own stock in the first quarter, according to S&P Dow Jones Indices. That is on pace for the biggest amount in any quarter, based on data going back to 1998. About 85% of S&P 500 components have reported so far.

Indeed, this largely debt-funded activity – or rather extremely cheap debt-funded activity…

… has been a panacea to corporations and their management teams, eager to boost not only their stock price but also their equity-linked compensation, in the process sending the overall S&P to new all time highs, as more and more shares outstanding are quietly taken out of circulation.

“The reason these companies are buying their stock is that they’re smart enough to know that it’s better for them than anything else,” said Charles Munger, vice chairman of Berkshire Hathaway Inc., at the company’s annual meeting last weekend.

It is hardly a surprise then that Berkshire Hathaway recently became the 3rd largest holder of Apple stock: having lost the ability to innovate, Tim Cook is now the single largest repurchaser of stock in the S&P500…

… having just bought back a
record amount of AAPL shares:

Incidentally, Buffett’s brief infatuation with IBM was for the same reason: until recently, Big Blue had been the biggest, most reliable repurchaser of its own stock. That all ended in 2014 when as we reported at the time, the company’s leverage became too big to sustain the surge in buybacks, sending both IBM stock price, and Buffett’s interest in it, tumbling.

Going back to the direct impact of buybacks, contrary to the false public perception that buybacks do not work, perhaps as a result of charts such as this one by Goldman which suggests that buybacks have done little to boost stock prices, which in retrospect is absolutely wrong…

… the WSJ found that repurchases have been especially effective in raising stock prices at a time when most others – both retail and institutional investors – have been selling. In fact, according to the Journal, companies repurchasing their stock have outperformed the broader market by over 170%:

Of the 20 S&P 500 companies that spent the most on buybacks over the first quarter, nearly three-quarters have outperformed the index so far this year. The group has risen an average of 5.2% in 2018, compared with the S&P 500’s 1.9% gain, according to a Wall Street Journal analysis of S&P Dow Jones Indices data.

Some examples:

Apple Inc., the largest U.S. company by market value, said last week that it would embark on a $100 billion buyback program. The stock surged 4.4% the following day and 13% for the full week—marking its biggest one-week percentage gain since October 2011.

Microsoft Corp.’s stock has risen 14% this year, after the company bought back $3.8 billion in shares in the first quarter. Boeing Co. , JPMorgan Chase & Co. and UnitedHealth Group Inc. are up this year after big first-quarter buybacks.

To be sure, buybacks have not worked for everyone: Amgen, the second-largest buyer of its stock among reporting companies in the first quarter, repurchased $10.6 billion of shares in the first three months of the year, and yet its shares are down 1.8% this year. That, however, hasn’t stopped companies from continuing to pump cash into buybacks. Amgen expects to buy back between $2 billion and $4 billion more of its stock in the second quarter, the pharmaceutical giant said.

How much longer can this continue?

The answer may well be “indefinitely”, especially with debt interest rates still very low relatively to the pre-central planning era, which means companies will be able to keep issuing debt, gobbled up by yield-starved managers of other people’s money, for the foreseeable future, until one of two things happens: i) rates jump to the point where it is no longer economic to repurchase stock at the expense of incremental interest expense, or ii) there is no more public stock to repurchase.

While the second may appear to be a joke, an analysis by JPM on Friday found that at the current rate of stock buybacks, all else equal – i.e. assuming no new stock issuance – the S&P will LBO itself in about 77 years. Here is the math from JPM’s Nikolaos Panigirtzoglou:

The Divisor of the S&P500 Index, proxied here by the ratio of the free float market value divided by the price, is shown in Figure 2. Between 2014 and 2017 the S&P500 Index Divisor had been declining by 1.3% per annum. YTD it declined by 0.5% which annualized stands 20% above last year’s pace.

And this is what the accelerating LBO of the S&P500 looks like:

Some additional observations from JPM:

while our expectation remains that corporate buyback activity will increase this year vs last year due to repatriation flows as well as strong earnings growth and corporate tax cuts, thus far in 2018 it seems that most of the increase is concentrated to a few large companies and the share buyback increase for the overall US equity market has been more modest.

Others disagree, such as BofA managing director Jake Mendelsohn, who leads the desk that does corporate buybacks: “Activity is very widespread and we’re seeing it executed in a lot of ways.“

And while nothing appears able to stop, or even slow down, the slow-motion LBO of the entire market, the reality is that while rewarding shareholders in the short-term while boosting your own stock price does miracles for management morale (by way of equity-linked comp), the trade off is the vibrancy, productivity and global leadership of America’s corporations: critics say spending on buybacks comes at the expense of spending on R&D, hiring and equipment upgrades — things they believe are the ultimate drivers of growth over the long run. Of course, we all know what also is true about the “long run”…

Meanwhile, the topic of buybacks is so controversial, not even Charlie Munger can stop himself from yet another episode of demented hypocrisy, saying that buying shares just to keep the stock up is “insane and immoral.” Ironic, considering Berkshire just announced it bought another 75 million shares in the world’s biggest repurchaser of stock…