In the first quarter of 2014 stock-buy backs have reached USD 160 bn. This marks the highest quarterly reading in this up-cycle (see chart below). If buy-backs continue at this pace a new yearly record will be set some when around summer. Now, what do we make of these numbers? Bullish or bearish?
With net equity fund flows persistently negative, corporates have been the net buyer for many quarters in a row. Some observers, as Martin Armstrong for instance, see this as a bullish sign from a technical perspective interpreting the weak mutual fund flows as a sign that the bulk of the investors has yet to jump on the stock bandwagon, ultimately driving stock prices up further. According to this logic, no rally is complete without the “retail-suckers” getting screwed. To Martin’s credit, his argument has solid empirical evidence backing it up and it is not easy to argue with.
Although I am not competent to give advice on technical matters (having missed a good part of the rally sitting on a large cash position for 14 months now), I still fail to understand how the retail investor is going to drive this market higher. With savings rates that low and a weak economy, where is he/she going to take the money from? The rich already have plenty of shares and seem to get interested in more profane things…
Regardless, I want to focus on the fundamental implications instead. Contrary to what many seem to think, buy-backs are no panacea. They only make sense if the stock trades below its intrinsic value and no better investment opportunities are available. Buying back overvalued stock destroys shareholder value as you give up valuable cash (or you risk your credit rating in case the buyback is financed by debt) for something that is too expensive. Not all shareholders are getting harmed to the same degree, though: short-term shareholders, i.e. those that are willing to sell into the rise, benefit at the expense of long-term investors who ultimately are harmed by the wrong capital allocation decisions. (so you also get a nice long-term negative selection problem)
Now, none of this matters of course if you are in the mainstream financial economics camp: markets are efficient and there are no systematic over or under valuations. This view holds that either buy-backs don’t matter or that, if they are treated differently than dividends from a tax perspective – as is the case in most jurisdictions, buy-backs might even be of some benefit (mostly tax-arbitrage).
While I am a big fan of supporting one’s opinion with theory, I do not subscribe to the above view. First, most financial models (such as the CAPM) are one-period models, completely neglecting multiperiod dynamics. They are therefore completely unsuited analyzing situations where decisions that are made now (such as issuing debt to buy back stock) are affecting my opportunity set and decisions in the future (i.e. I have to pay back the debt). These are only captured with math-heavy multiperiod models which need stronger assumptions (removing them further from reality) in order to be tractable. Second, principal agent considerations are implicitly neglected although managers, long-term stockholders as well as speculators rarely have the same utility function. Given that corporate management decides whether to buy back or not and given that incentives MATTER, it makes sense to look closer at their motives. (CAPM assumes all agents have the same risk preferences and objectives, making it a non-subjectivist theory)
Although one would assume that managers know best whether their stock is under or overvalued, I have made the experience that the average board member knows about as much about valuing a company as your average grandmother. It has been well known that the majority of acquisitions destroy value, which in literature is usually explained by management’s desire for empire building or such phenomena as the winner’s curse (Buffett’s advice never to participate in auctions comes to mind). Managements, the research suggest, are prone to emotional overbidding rather than being cool calculators with a maximum price in mind. So far, so good. What is less well-known however is that management’s track record in buying back its own stock doesn’t look that great either, as the following chart demonstrates.
The chart is somewhat outdated but given that buybacks, the market and debt issuance have continued to climb, the pattern has been more or less adhered to. We see that debt issuance AND buybacks have been at the highest at the prior market peak and lowest at market bottoms! With the benefit of hindsight, we know for sure that directors buyback decisions have been terrible over the most recent fully completed cycle. Further, regardless of whether you think that the market is currently overvalued or not, it cannot be denied that it would have been a much better decision to buy back stock in 2009/2010 than now. Yet at the bottom of the last crisis there were ZERO net equity buy-backs! If anything, they were net issuers in order to repair their balance sheets (including financials in the above chart would worsen the picture dramatically) Now, neither the winner’s curse nor empire building cannot account for that. If not, what can?
You will also notice from the chart that buy-backs at such a large-scale are a phenomenon of the past 15 years. Prior to that they were quite rare, directors preferring paying out dividends instead. It is no coincidence in my view, that over the same period the amount of CEO compensation tied to stock performance indicators (EPS, stock option grants…) has increased dramatically. By buying back stock CEOs can directly impact EPS and hence the stock price without changing the fundamentals of the company in a significant way – clearly the incentives are stacked in favor of buy-backs over (tedious) improvements in operating performance. Buying-back stocks makes you a Wall-Street darling, Manhattan dinners, booze and hookers. Do not think these things have disappeared, just because they brabble something about “ethical conduct” in their annual report. Building a new plant and negotiating with local majors and enviromentalists is clearly less of a thrill.
An efficient market’s believer might object, that it is the role of the debt holders (who usually provide the funding for buybacks) to instill discipline on managements, and that the monitoring at least in deep american markets should work properly. My concerns, therefore only apply to “backward” financial markets. Now, this view again overlooks two things. First there is a principal agent problem at the investor level as well, since most institutionals manage “other people’s money”. Second and related to my post two weeks ago: in a period characterized by low-interest rates and the corresponding “hunt for yield”, decision makers at all levels are prone to miscalculate the odds of investments in a systematic (albeit non scientifically quantifiable way) – even if properly incentivized!
Given the fact that buy-back activity as well as debt levels (see chart below) are at record highs and taking into account directors’ and lenders’ skewed incentives, coupled with their horrible track record, I think the buy-back data rather confirm my overvaluation thesis. If I am correct, every quarte that passes destroys shareholder value on an aggregate basis increasing the probability of a nasty bear market and record debt defaults.
Graph: Total as well as net corporate debt at all time highs.