Perusing my charts over the weekend, it dawned on me that two current market phenomena are coming to a head →Buybacks & ETFs. Both are very prominent trends that have created a powerful feedback loop which I believe has a myriad of implications for the current market structure. So, let’s dive in!
Historically, stock buybacks were shunned because firms feared charges of market manipulation, as a result US companies would predominately return cash to shareholders vis a vis dividends. In fact, according to Goldman Sachs, from 1880-1980 the dividend payout ratio of the S&P 500 averaged a whopping 78% of earnings. If a buyback was deemed appropriate it was done by a tender offer conducted at a certain time and certain price, not ad hoc on the open market.
The world changed in 1982 with the advent of regulation 10b-18 which provided companies a safe harbor against market manipulation when repurchasing their shares in the open market. Share repurchases today have grown at the expense of dividends with the number of S&P 500 firms repurchasing shares over a trailing 12 months going from 196 in 1992 to 424 in 2018 (Goldman Sachs). The money being spent is absolutely jaw dropping. According to Ned Davis Research, since 2011 S&P 500 companies have spent $3.5 TRILLION in buybacks, and that’s just S&P components!
As this new buyback phenomenon has transgressed, another financial wave has swelled with passive investing, particularly in ETFs. Since the financial crisis, over $2.5 TRILLION has flowed into passive equity instruments and another $1 TRILLION has flowed out of active management (Morningstar).
This is where a feedback loop has been created; a company buys back stock reducing share count, while simultaneously ETFs are systematically (and indiscriminately) increasing share demand. In a recurrent cycle, I believe we have formed a kind of “Passive Bubble.” And the ramifications of this are important.
For one, these buybacks have just exacerbated the reach for yield for traditional dividend seekers, with a recent Merrill Lynch survey showing 0% of investors reaching for yield in stocks over a wide myriad of other financial instruments some of which – like junk bonds and leveraged loans – carry a good deal of risk.
Second, the vast amounts of money being piled into buybacks has quelled growth and innovation. For example, U.S. technology companies have spent 55% more on repurchases in 2018 than 2017 (Bloomberg). Wouldn’t it make more sense to be doing M&A or spending on R&D? At a minimum, one must question the motivation behind some buybacks, especially as shares trade at high multiples. Are companies getting long term benefits or short-term thrills, and what are the consequences of an unwind?
Thirdly, a recent study by the SEC found a pattern between stock buybacks and insider selling. Specifically, many corporate executives were found to have sold significant amount of their own shares after they announce a buyback. Importantly, the report showed that the share price of these companies under-performed the broader market in the long run.
Finally, the most important thing I’d like you to take away from this insight → finding companies that have true secular growth outside of this kind of financial engineering has a lot of merit and that’s what the suite of Essex Evolution products are all about!
Thank you! Please reach out anytime with any questions or comments!
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