Buyback Stats

Buybacks are surprisingly controversial. You wouldn’t think buybacks would be such a big deal because they are just an alternative way to give excess cash back to shareholders. However, they are blamed for the lack of productivity in the economy and juicing EPS numbers. If firms buyback stock instead of investing in capex, then it can hurt the productivity of the economy. However, the issue is not having a place to put the money; it’s not the place the money goes afterwards. Buybacks can increase EPS numbers if the share count is reduced. It’s not necessary to discuss how the EPS numbers are fake, because everyone on Wall Street knows how earnings per share work. It’s not tricking anyone. You can look at sales growth to tell the health of the business. If sales are slowing, then the ability to continue buying back shares to boost EPS numbers won’t last long.

It could be argued that buybacks boosting EPS numbers aren’t the problem. I think the problem is when retail investors don’t realize how share counts might not be reduced by buybacks if firms issue more shares through compensation, then they buyback. It’s worth noting that the buyback isn’t at fault in this case. The problem is paying management and employees too much money. If people mad about buybacks said money that’s spent on executive compensation should be invested into the business, most people would be on board with that because companies that pay their CEOs the most have much worse performing stocks over the past 10 year than those who pay their CEOs the least.

The chart below is another interesting stat. Firms that buyback the most stock underperform the market while those who don’t buyback stocks outperform the market. This shouldn’t be taken the wrong way. Buybacks are money returned to shareholders. The act of doing this isn’t the problem. The problem is when companies aren’t in a position to invest in new products, it could be a bad sign. It could mean their business is in decline and management can’t fix it. It’s also worth noting that profitable companies need to return cash to shareholders. I’m just trying to review possible explanations for this chart. Keep in mind this is an average stat just like the CEO pay stat. The difference is CEO pay is often not properly aligned with performance as firms give golden parachutes to executives who are fired after doing a bad job.

This leads us to the latest information on buybacks. As you can see from the chart below, buybacks have been declining for 2 quarters in a row. The last time buybacks fell, it meant stocks were running out of earnings to use on buybacks. Earnings peaked in Q3 2014. That’s why it makes sense buybacks peaked this cycle around that time as well. The question is whether buybacks rebound or not in Q3 now that earnings are back to the peak. It’s possible the money will be allocated differently. It’s also worth noting that when earnings fell from Q3 2014 to 2016, dividends were rising. That means there’s less money available for buybacks with earnings at the same levels. We probably need to see earnings exceed the Q3 2014 peak before buybacks reach the levels seen in 2016.

Whether or not buybacks return to their previous peak, there appears to be an increase in capex. As you can see from the chart below, the Philly Fed’s diffusion index which measures firms’ propensity to make capital expenditures is showing that more investments are planned on being made. That’s a great sign for the economy. It’s important to note that stocks have gone higher this year even as buybacks have fallen. That puts an ax to the concept that the stock market is in a bubble fueled by buybacks. If buybacks improve along with capex, it puts an ax to the concept that firms are using money on buybacks instead of capex. Obviously, the improvement in capex is a great sign for the economy. The fact that firms are willing to utilize capital on their growth projects shows firms are confident in the long term prospects of the economy. They have the same confidence consumers are exuding.

As I said with the chart showing returns of companies with high amounts of buybacks compared with low amounts of buybacks, this doesn’t imply buybacks are bad. The chart below supports that claim. As you can see, there isn’t a relationship between returns to shareholders and the mix between buybacks and dividends. The reality is buybacks are done for tax purposes. When a firm buys back a stock, there’s no capital gains that need to be paid if the shares aren’t sold. On the other hand, cash dividends are taxed. If dividend taxes were lowered ore removed, more dividends would be issued.

The final chart we’ll look at shows hypothetical examples where companies that are profitable end up having to give money back to shareholders even after they reinvest money into the business such as through advertising and research and development. As you can see, the excess capital can’t be reinvested. A company can either hold it on the books, make an expensive acquisition, or return the money to shareholders. It’s wrong to make a blanket statement that buybacks are bad for the economy and investors. Sometimes buybacks are a mistake. Sometimes companies don’t invest in capex. The point here is that a normal company should have money to return to shareholders. You shouldn’t criticize a firm for making logical decisions with the money.

Conclusion

Buybacks are controversial, but they shouldn’t be. Sometimes bad arguments are made surrounding them. It’s important to realize that stocks’ performance in the next 12 months has more to do with earnings growth than buybacks. It’s a great sign than earnings are up to their all time highs and capex is improving. There’s no reason to worry about buybacks creating a bubble because they are just an alternate way to return capital to shareholders that has become more popular in the past few decades.

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