I’ve discussed before on this blog the trend for companies to issue debt then use the proceeds to buy back their own shares. Today I’m going to look at the impact of share repurchases on equity markets. The chart at right shows the increase in share repurchases.
When the interest rate paid on the bonds is lower than the dividend yield on the shares being repurchased, this is a cash-flow positive strategy. Here’s the math, using small numbers just to keep it simple.
A company’s stock is trading at $100. The current stock dividend is 4% on an annual basis, which means it is paying $4.00 in dividends on every share per year.
The company issues $1,000 worth of bonds yielding 2.5%. This means that if you bought $100 of this bond, you would receive $2.50 a year in interest payments. The company uses the proceeds of the bond issuance, (the $1,000) to repurchase 10 shares of its own stock (10 * $100/share = $1,000). Now the company is paying only $25 a year in interest versus the $40 it was paying previously.
Looking at those equations one can see how low interest rates, (a la Federal Reserve Quantitative Easing) could make it more attractive for companies to buyback their shares and would put downward pressure on dividend yields. So let’s look at the magnitude of share buybacks.
Well that sure seems like a lot of money going into share buybacks, and that is just the top 12 by volume (number of shares). Let’s look at the top 10 companies by dollar-value and their share returns.
Looks like overall, this proved to be a strategy that is at the very least, correlated to shareholder-pleasing stock price gains. (Keep in mind that executives often have their compensation tied to improvements in share price.) How could these share buybacks affect share prices and not just reduce the amount of money companies pay out in dividends?
The price of a stock on any given day is just a function of supply and demand. The greater the demand (buyers) the more the stock price is pushed up until no more buyers are interested at the higher price. The converse is also true, the more that want to sell, the lower the price will go until no more sellers are interested in selling. (Real world example – when home prices are high, lots of people consider selling their homes, but when home fall, more people are happy to stay just where they are.)
So how big of an impact do these share buybacks have on demand? We can answer this buy looking at fund flows, meaning money going into and coming out the markets.
The chart above shows that the single largest source of funds going into the equity markets came from corporations. Households on the other hand were net sellers. This chart shows that in 2014, household took $183 billion out of the stock market while corporations put $415 into the equities market. If no corporations had purchased equities, there would have been a net outflow of $237 billion dollars! Talk about a reduction in overall demand.
Now let’s go back to the company making the decision to issue bonds, (borrow money) and use the proceeds to buyback shares of their own stock. There are a few things to keep in mind:
- This is not a sustainable process. Companies cannot endlessly issue debt then use the proceeds to buyback shares – rather intuitive, but something to keep in mind as it is not a long-term way for a company to generate returns for shareholders.
- If stock prices fall, then the entire equation we did above falls apart. How’s that? Well I left out the impact of share price and the company’s balance sheet in that analysis. (Tricky aren’t I!) So let’s revisit that equation taking share price into account.
The company issues $1,000 worth of bonds and immediately buys $1,000 worth of stock, or 10 shares since the stock was trading at $100/share. So on the company’s balance sheet there is now a liability worth $1,000, but an asset that is worth $1,000 counters it.
If the company’s stock were to decline by say 15%, then those shares would be worth $850. The company now has a liability worth $1,000 that is countered by an asset worth only $850. This negative change in the company’s net worth makes it less attractive than before the share price decline, so now it has a double hit. Its shares have been falling and now its balance sheet looks less attractive. That can put further downward pressure on the company’s share price, which results in an even less attractive balance sheet and so on. This is another example of how debt can exacerbate problems when asset prices fall.
Now that I’ve mentioned asset prices… well that brings up the Fed and for that matter, most all central banks these days. The goal of loose monetary policy is to induce borrowing which is intended to generate economic activity and drive asset prices up, so if there is a material decline in asset prices, we wouldn’t be surprised to see the Fed step in to try and push prices back up… that is if/until monetary policy is no longer capable of doing so. As the saying goes, “We live in interesting times.”
One more little bit to contemplate is the relationship between company profits and the growth of the economy. The chart at right shows how the six-month change in 12-month forward earnings per share is closely correlated with changes in real GDP. Notice how most every time the change in EPS goes negative, the economy contracts – again we work with probabilities, not certainties, but one must always keep an eye on the data and the correlations.