Corporates are the marginal buyer – Does it matter?

Interesting Table by Goldman (via ZH) which breaks up US equity flows
GoldmanEquityFlows
We also know that a lot of that buying is funded via debt issuance, or in the words of Stan Druckenmiller,

(…)But then they increase their debt 600 billion. How did that happen if they didn’t have negative cash flow? Because they went out and bought $567 billion worth of stock back with debt, by issuing debt. So, what’s happening is their book value is staying virtually the same, but their debt is going like this. From 1987 when Greenspan took over for Volcker, our economy went from 150 percent debt to GDP to 390 percent as we had these easy money policies moving people more and more out the risk curve. Interestingly, in the financial crisis that went down from about 390 to 365. But now because of corporate behavior, government behavior, and everything else, those ratios are starting to go back up again (…)

Goldman’s figures show that for the past years corporations have been the marginal buyer of US equities. This, I believe, is a very helpful technical input to my fundamental market view.

Contrary to what mainstream capital pricing theories imply, the observed price of an asset is not some objective value where every agent agrees on expected cash flows and risk premium and valuation becomes a discounting exercise in equilibrium (the real world is never in equilibrium). Instead it is the result of the last transaction involving a specific seller/buyer. And knowing that marginal seller gives us valuable information on their expectations. To me it makes a difference whether the last quoted price is the result of, say, Warren Buffet buying from a distressed Goldman, or whether Mrs. Watanabe is the buyer.

So, corporations are borrowing debt at record low rates to buy back debt, is this good or bad? Surely, corporate CEOs are not Mrs. Watanabe (but they are probably no Warren Buffet either).

In order to answer this question I think it is necessary to look at three things:

  • Track record
  • Motivation
  • Implied expectation

Track record

This is an easy one. I am sure you are all familiar with this chart which I have already referred to in the past.

StockbuybacksvsEquity

The timing of CEOs over the past cycle was not terribly good, sort of “sell low”, “buy high”. This, of course, is not a statistically significant result, but there is robust academic evidence that acquisitions, which require similar valuation skills, are value destructive. In my experience most CEOs have no clue how to value companies or how to allocate capital and have become who they are either because they are good operators, or skillful in company politics, not because of supreme capital allocation skills. In short: the overall track record of management valuing whole companies doesn’t inspire confidence.

Motivation

The main reason that’s often quoted as a positive by analysts is that buybacks deliver EPS growth in a low (revenue) growth world.

The problem with this argument is that EPS growth might a good proxy for a positive NPV investment, or it might not be. Technically, as long as the earnings yield of your shares is above the yield you pay on the debt an equity buyback is EPS enhancing. If you believe this to be a reasonable proxy, you also have to be willing to stay in or out of the market based on a simple trailing PE ratio (and nothing else). By the way, that’s probably how Mrs. Watanabe buys stocks 🙂

A second reason has certainly to do with the fact that management compensation is either directly tied to EPS growth, or indirectly, as is the case with stock option compensation where the strike price of the option doesn’t adjust with the changes in shares outstanding. It is easy to see how management will go to great lengths justifying buybacks when given such incentives.

This apparent conflict of interest and the naïve argument given on why buybacks are good do not inspire confidence in me. No doubt, management has an incentive to overpay. Think about who the likely patsy is in this game…

Implied expectation

Now let’s play a little armchair economist.

Stocks are very long-term financial assets. It follows that at a PE ratio over 20 (and assuming that earnings are sustainable and a good proxy for cash flow) payback of the average stock buyback is more than 20 years. Since these are typically funded with debt that matures in 5-7 years, it means that this investment will likely have to be refinanced. Although there is lots of talk about “locking in” record-low interest rates, this nonsense: bond-financed buybacks create large (implicit) maturity mismatches.

I know what you think: debt is paid back out of operating CF (EBITDA or EBIT) and these multiples are way lower than PE ratios hinting at a much quicker payback and no need for refinancing. The problem with this view is that in order to reduce the refinancing risk, management has to divert cash flow from growth or maintenance capex to debt repayment – hardly a bullish argument. To be sure, there certainly are companies out there that need to be liquidated, and funding this via low-interest debt certainly makes sense (for shareholders). But it is the one argument I have never heard as a reason for buybacks.

It boils down to this: by making this bet management assumes that it will be able to refinance at record low-interest rates AND credit spreads over the next 20 years. I know, investors are not overly worried about raising government bond rates, but are they equally confident that that credit spreads will stay at current levels for the next two decades? I think if you frame the question in this way more people would come to the same conclusions as me…

Conclusion

For the reasons listed above high buyback activity is a negative technical indicator which adds to my fundamental worries about the market. My strategy regarding equity stays the same: keep exposure constant until your price target is hit and then load up on puts.

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