US share buyback flurry ‘may have run its course’

The positive impact of share buybacks by US companies appears to be fading and will likely be less able to continue to propel stock prices higher, according to Capital Economics.

John Higgins, the group’s chief market economist, said net equity issuance by US companies (ex-financials) had been negative for all but two of the past 46 quarters, with a -$407bn (-£243.3bn) annualised figure in the fourth quarter of 2013.

He added: “Data compiled by Bloomberg suggest no let up this year. The total volume of buybacks in Q1 2014 among S&P 500 companies is estimated to have topped $150bn, the highest figure since Q3 2007.”

Article continues after advert

According to Mr Higgins, there are four key explanations for the popularity of buybacks.

“They are a more flexible way of distributing money to shareholders than dividends, enabling companies to return surplus cash without setting a clear precedent,” he added.

“They may have been undertaken by companies wanting to send a signal that they think their shares are undervalued or by management teams rewarded with share options. They also arguably reduce firms’ overall cost of capital.”

While taxation has historically favoured buybacks – investors usually pay less on capital gains than dividends – the top rate of tax in the US is currently 20 per cent on qualified dividends and long-term capital gains.

“There can be little doubt share buybacks have provided a boost to the stockmarket in recent years: the S&P 500 Buyback index, which tracks the 100 shares with the highest buyback ratios, has nearly doubled since the beginning of 2008, exceeding the 30 per cent gain in the overall S&P 500,” added Mr Higgins.

“But the outperformance of companies engaging in large-scale buybacks may have run its course. Having risen by more than the broader market in the past five years, the Buyback index has lagged so far in 2014.”

While this may just be a bump in the road, Mr Higgins said, there were various reasons why debt-financed share buybacks should not provide much of a boost to share prices.

Fundsmith founder Terry Smith also has serious concerns about buybacks, as repurchased stock disappearing from the balance sheet can be used to distort company performance.

“[By executing a share buyback,] companies can inflate their earnings per share and are almost universally seen to have created value for shareholders when mostly they clearly have not,” he said.

“Buybacks only create value if the shares repurchased are trading below intrinsic value and there is no better use for the cash that would generate a higher return.”

Any companies engaging in buybacks should be required to justify this use of cash with reference to the price paid and the implied return, and also compare this with alternative options, Mr Smith said, adding that investors and commentators should analyse share buybacks on the same basis as they would if the company bought shares in another company.

Nordea’s Ed Cowart, manager of its Nordea-1 North American All Cap fund, said companies may be realising the limitations of buybacks after their widespread use.