Share buybacks have been credited with fuelling the longest equity bull market in US history. So the recent headlines that dozens of US companies are now ending this practice has intensified investor unease about the depth of the market sell-off.
A share buyback is where a company buys back its own shares from the marketplace. This reduces the number of shares outstanding and as a consequence boosts earnings per share (EPS) and the company’s stock price. But these buybacks can be cut when cash preservation and credit worthiness are a priority.
Fast-food chain McDonalds, electronics retailer Best Buy and telecom provider AT&T have all suspended buybacks to shield themselves from further economic damage as a result of the Covid-19 outbreak. The longer the virus lasts and the greater the need for cash, the more likely it is that other companies will follow suit. This could cut a layer of support for markets at a time when they need it the most.
However, our research suggests that fears that a collapse in the number of share buybacks could accelerate the market downturn are overblown. The impact of this move on the overall market is likely to be more limited than widely believed. The pace at which the global economy recovers after the coronavirus pandemic will be the most important driver of profit growth, not share buybacks.
Markets have priced in a deteriorating buyback outlook
Warren Buffet once said “only when the tide goes out do you discover who’s been swimming naked.” As the buyback boom comes to an end, companies that have “juiced” their EPS growth and thus their share prices are likely to be disproportionately affected.
Such firms are already under pressure. The top 100 companies with the highest buyback ratios (buyback volume relative to market cap) have outperformed the broader market since 2008. However, in the first quarter of 2020, they tumbled by 31% compared with a loss of 21% for the S&P 500.
Source: Refinitiv Datastream, Schroders. Data to 27 March 2020.
Why buybacks matter
Investors fear a buyback bust because corporate America has been the single, largest source of demand for equities since 2007. And indeed, on a net basis, corporate equity purchases vastly exceed other sources of demand, as the chart below shows. ETFs were the second largest buyer, but still lagged behind corporates. Meanwhile, pension funds, households and mutual funds were all net sellers.
Source: Federal Reserve, Schroders. Data to 2019.
Corporate purchases have been driven by a combination of buybacks and mergers and acquisitions (M&A), with a roughly 50/50 split of each. However, both are likely to dry up soon. Buybacks in the final quarter of 2019 were already down 20% from a year earlier and M&A activity has fallen by 51% in the first quarter of 2020, the worst annual fall since 2008. If these trends continue, the market drawdown could be exacerbated and delay the recovery in equity markets.
The main issue with this framing is that it disguises which companies have been doing most of the buying. For example, the 500 largest US companies spent $3.2 trillion on buybacks over the last five years, according to data from S&P Dow Jones.
Yet the top 20 companies accounted for nearly a third of this total and Apple alone accounted for 8%. A more nuanced analysis shows that the net effect of removing buybacks will be most felt in a handful of sectors and companies.
Which sectors are most vulnerable in a world of no buybacks?
EPS is equal to net income divided by the number of shares outstanding. As a result, if EPS grows faster than net income, this must mean a net reduction in the number of shares outstanding (buybacks exceeded share issuance). If EPS grows slower than net income, this must mean a net increase in shares outstanding (share issuance exceeded buybacks).
Over the past five years, the gap between annual EPS and net income growth was around 1% for the average S&P 500 company. In other words, net buybacks boosted EPS by only 1% each year. To put this into context, the annualised total return of the S&P 500 was 11% over the same period. So despite all the hype about buybacks, they have been fairly insignificant for the average stock. This revelation may come as a surprise but it is backed up by academic evidence.
Nevertheless, the distribution of this effect has been highly uneven. In certain sectors and companies it has had a significant impact (see chart). In these cases, buyback suspensions could weigh heavily. Consumer discretionary and industrial stocks are most at risk.
On average, they have boosted their annual EPS growth by 4.5% and 3.7% a year, respectively. Ironically, these industries are also more likely to cut buybacks given their sensitivity to travel restrictions and plummeting consumer demand.
In contrast, buybacks have had little impact on more defensive areas of the market such as consumer staples and healthcare. They look less vulnerable from this perspective. On the other side of the scale, companies in a number of sectors have been net issuers of shares over the past five years so have received no boost from buybacks (the opposite, in fact).
Source: Refinitiv Datastream, Schroders. Data from 2014 to 2019.
Not all stocks will be equally affected
Although these sector distortions may appear modest, they are more skewed at the security level. Of the 300-odd companies in the S&P 500 that saw profit growth over the last five years, 65 names, or 21% of the universe, boosted their EPS growth by as much as 25%.
Another 41 companies, or 13% of the universe, more than doubled their EPS growth. For example, Starbucks’ net income growth was only 12% per year but its EPS growth was 77%. Reported EPS growth was 6.6x higher than it would have been without buybacks.
Similarly, Hilton Worldwide, the hotel chain operator, reported EPS growth that was 4x higher. Both companies have been forced to shut down operations in several countries in light of the virus outbreak. These results are summarised in the next table.
The buyback tailwind could turn into a share issuance headwind
One possibility that cannot be ruled out is that there is a complete reversal in this trend, with companies not only being forced to halt buybacks but going further and issuing new shares. This would act as a drag on future EPS growth. Investors forget that before 2004, equity issuance regularly exceeded buybacks.
A repeat of such a scenario is a realistic prospect. Some companies will be forced to repair their balance sheets and reduce leverage to avoid their credit rating being downgraded. For example, Carnival, the US cruise operator, has announced it will suspend buybacks and instead raise equity to help stay afloat amidst deteriorating economic conditions.
The number of companies that follow will depend on the severity of the damage caused by the current downturn and the need for equity financing.
Loss of buyback support will be felt unevenly
This is clearly an additional headwind for markets at a time when they do not need one. However, fears that this will severely deepen the market downturn are overblown. The impact at the overall market level is likely to be more limited than widely believed. The pace at which the global economy recovers is likely to be the most important driver of profit growth going forwards, not buybacks.
That does not mean that investors should ignore developments in this area. Some stocks and sectors face significant headwinds from loss of buyback support. Stock pickers should be more attentive to those which are most at risk.