Corner of Wall & Main: Buybacks Trouble

 | Jul 02, 2014 | 2:00 PM EDT  | Comments
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History may not repeat itself, but it does rhyme and the tune these days is becoming increasingly reminiscent of the ultra-low volatility and complacency of 2007. Despite increasing inflationary indicators, the markets appear quite convinced that any tightening by the Fed is highly improbable, with any eventual action being only the slightest brake tap.

All major asset classes are up on the year, even those that are typically inversely correlated, making for the broadest rally since 1993. This brings to mind another song from the past of prolonged Fed easing after a real estate and credit crash. That tune as well came to a rather abrupt change after unanticipated Fed tightening the following year. The most recent Bank of America Merrill Lunch poll of institutional investors reports that a net 48% are overweight equities, despite 15% believing that stocks are overvalued. Then there was Sunday's bomb.

The Bank of International Settlements (which provides financial services to national central banks and also acts as a setting where central bankers can discuss monetary policy and other issues like financial stability or bank regulation) issued its annual report. It contained an unusually loud warning:  "overall, it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally." With respect to corporations, the organization stated additional concerns that "despite the euphoria in financial markets, investment remains weak...Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions."

That last bit ought to really get your attention. If we look a bit deeper into the data, it turns out that the usual buyers of stocks such as hedge funds, pension funds, mutual funds etc. have been, in aggregate, net sellers. The big buyers have been the companies themselves! Hold on a minute. Stock prices have been going up because companies are buying back their own stocks? 

American companies have been buying back shares at an annualized rate of $400 billion in Q1, according to the Z.1 data from the Federal Reserve Bank of St. Louis. This is equivalent to 2.5% of GDP! The prevailing narrative has been that corporate balance sheets have never been healthier, so debt issuance for share buybacks ought not be a major concern. Yet the reality, according to Andrew Lapthorne of Société Générale, is that net debt in the US corporate sector is at a record $2.3 trillion, up 14% over the past year, with the ratio of long-term debt to total assets near the 2009 peak.

Now there isn't anything innately wrong with companies buying back their own stock and in fact we are often quite in favor of it. But there is a reason to be concerned when it appears that these buybacks are a significant driver of upward market momentum! We've seen a disturbing trend with these large-cap companies issuing bonds in order to buy back their own stock, which we are sure has nothing to do with executive compensation packages tied to stock performance, (not even attempting to hide the snarky undertone here) such as with Monstanto (MON), Apple (AAPL), Cisco (CSCO), and Fedex (FDX). 

If we look at returns year-to-date by capitalization, we can see some of the impact of such buybacks, with the S&P 500 7.2% up, S&P Midcap up by 7.01% and the Russell 2000 (small cap) up by 2.89%.  Clearly the equity market is frothy and on a price-to-sales basis the S&P 500 is trading at more than a full standard deviation above normal, while outlays have been cut to the bone with historically exceptionally low capital investment. 

That being said, share buybacks, when properly funded, can be a fantastic way to reward shareholders without the taxation involved with cash dividends, which is a particularly prickly topic with the 3.8% surtax on investment income to fund the Affordable Care Act. The AdvisorShares TrimTabs Float Shrink ETF (TTFS) is an actively managed ETF that weighs a portfolio of 100 stocks equally, regardless of size, which have decreased outstanding shares over the past 120 days via strong free cash flows rather than debt issuance. Using this strategy, the ETF has handily beaten its benchmark, the Russell 3000, over the past two years.

The PowerShares Buyback Achievers ETF (PKW) also looks to take advantage of buybacks, by only including those firms that have reduced outstanding shares by 5% or more in the past 12 months, reconstituting its holdings annually at the beginning of the year and rebalancing on a quarterly basis, weighting holdings by market capitalization. To be included, a stock must also have an average daily cash trading volume of $500,000 and trade on the NYSE or NASDAQ. Firms that have reduced their shares outstanding by 5% or more over the previous year are unlikely to consistently do so, thus the fund can and has had a rather high turnover. PKW has also consistently outperformed the market with this strategy, handily beating the S&P500 over the past two years.

The most dangerous part of the market today though is in bonds, where corporate bond spreads are now just a handful of basis points shy of the 2007 cycle lows while we are seeing potential hints of rising default rates in high-yield, up to 2.1% from February lows of 1.6%. In three of the past six months, non-investment grade credit rating downgrades have outnumbered upgrades. We are also starting to see trading volumes in relation to the stock of outstanding emerging market debt falling. The bond market is starting to flash subtle warning signs. Investors ought to take heed, particularly if inflation runs hotter than expected.

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