Friday, December 19, 2014

There's More To Share Outperformance Than Stock Buybacks

Stock buybacks have been grabbing a lot of headlines. Goldman estimates that buybacks in the S&P will amount to $600b in 2014, a 26% rise over 2013. And this comes on top of a 20% rise the year before.

Buybacks are, in a sense, the opposite of a dividend. Dividends pay investors cash and reduce the share price by the same amount. Buybacks use cash to buy shares, reducing the number of shares outstanding and thereby increasing EPS; the value of the remaining shares are meant to increase in value. Instead of getting a dividend, investors are getting a better capital gain.

In practice, the math is not so neat. A dividend is a set amount paid to each shareholder. A buyback is an indirect way to increase the share price. Whether the price increases by the amount of the buyback in the time the investor is able to realize the gain is not a given.

Another wrinkle is that companies are continually issuing shares. Most prominently, executives are often given compensation in the form of share options; buybacks have become a way for the company to mop up the resultant increase in shares. Put another way, buybacks are often a way for companies to help increase the value of share options for their employees.

So while the dollar amount of the buyback programs have grabbed the headlines, the reality is the net effect has been much less. Most of the buyback has been offset by share issuance (red line). Share buybacks might amount to $600b in 2014 but, net of issuance, it'll be closer to $200b (blue line; chart from Ed Yardeni).

To be clear, corporate buying is a net positive for equities, but it is less than commonly assumed. The effect on per share figures, like EPS, is also often overstated. Rising EPS is driven overwhelming by better corporate results. Over the last three years, during which corporate buyback programs have totaled about $1,470b, shares outstanding have been reduced by less than 3%. That compares to an increase in EPS of about 24% (figures and chart below both from FactSet).

The chart above and those that follow below are from an excellent report on the topic from FactSet. We recommend reading it here.

Do shares of companies that have large buyback programs do better? The relationship is less clean than you might imagine.

FactSet divided the S&P into quartiles based on the size of their buyback program relative to their shares outstanding; quartile 1 had the largest buyback programs and quartile 4 the smallest. Quartile 1 companies (blue line) outperformed those in quartile 3 and 4 (red and yellow lines), as you would have guessed, but quartile 2 did better (green line). And companies that had no buybacks did the best (gray line).

These results are weighted by market capitalization, so a few big companies can skew the performance for each quartile. According to FactSet, if you equal weight companies that do buybacks, they outperform the S&P.

The main point is that there is more to share performance than simply the size and presence of a large corporate buyback program. Below are the ten largest buyback programs in 2014.

Apple and IBM rank one and two, but their share performance could not be less similar. Apple has massively outperformed the index in 2014 while IBM has underperformed. Most of the top 8 did well, but its hardly a clean profile.

Share buyback programs are a net tailwind for the market but there is much more to share performance than financial engineering.

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