In this month’s video, Investment Director, Ritu Vohora looks at the recent ‘buyback wave’ fuelled by corporate tax cuts. Do share buybacks only benefit company executives or do they also create long-term value for shareholders?
Equity markets extended their year-to-date rally in March, making Q1 2019 the second strongest quarter on record. Developed markets outperformed emerging markets during the month. However, domestic Chinese shares remained strong performers closing the quarter up 27% (in USD terms), as stimulus measures began to bear fruit and trade talks evolved. The S&P 500 delivered its best first-quarter performance since 1998, as the Fed maintained its dovish stance.
UK domestic stocks were among the weakest performers, hit by the ongoing Brexit turmoil. However, they remain among the strongest performers year-to-date. The more international FTSE 100 delivered positive returns in March, led by mining stocks – boosted by falling inventories and optimism around US-China trade talks.
US 10-year treasuries gained ground as the 10-year yield temporarily dipped below the 3-month yield for the first time since 2007 – sparking recession fears. Weaker European economic data also supported German Bunds. Elsewhere, Brent crude was up nearly 4% in March, extending its year-to-date gains. In currency markets, both the euro and sterling weakened against the US dollar.
From a sector perspective, technology continued to lead boosted by improved US-China trade relations. Consumer staples stocks also outperformed on the back of analyst upgrades. Financials lagged, with stocks coming under pressure as the market reacted to the US yield curve inversion in March.
US companies announced a record $1 trillion in stock buybacks in 2018 – the recent ‘buyback wave’, has been fuelled by a boost from cash repatriation and Trump’s corporate tax overhaul in late 2017.
Corporate buybacks have continued to hit the headlines in 2019 – with growing criticism in academia and, more recently, from US politicians. This has reignited the debate around the virtue of companies buying back their own shares. With a number of politicians taking aim at these companies – pledging to increase taxes and regulations to curb the practice and make the US economy fairer and more productive.
The accusations against firms implementing share buybacks, is that it only serves to benefit company executives – who are compensated for increasing earnings-per-share over the shorter term, while at the same time artificially inflating share prices. Additionally, this diverts cash that could otherwise be reinvested for growth, returned to shareholders through dividends or shared with employees. In recent years, companies have also been borrowing heavily to fund buybacks, increasing their leverage, and hence raising the risk shouldered by investors.
Interestingly, there is a noticeable divergence when comparing the uptick in buyback activity between the US and other regions.
This is likely a result of Trump’s tax relief policies, combined with comparatively lower regulatory hurdles in the US. Company boards and executives face conflicting incentives when authorising share buybacks. To combat their misuse, the EU regulates share buybacks under the Market Abuse Directive, while in the UK, the Investment Association produces guidelines for companies to only carry out buybacks, if they are in the best interests of shareholders. Greater regulatory alignment globally, could see this regional divergence narrow, and we would also expect to see a moderation in US buybacks in 2019, as the impact of tax cuts begin to fade.
While sceptics have garnered the limelight of late, there is a wealth of evidence suggesting buybacks can have a positive impact on a company’s long-term prospects and share price performance. Depending on the underlying health of the company, buybacks are generally well received by markets.
Indeed, investors can often penalise companies for ‘hoarding cash’ and not reinvesting it in the business or returning it to shareholders in the form of dividends or buybacks. Lack of visibility about management’s intentions can create uncertainty and lead to the stock being derated.
While a company can deploy cash in a number of ways, using excess cash to buy back its own shares, could signal that management believes the stock is being undervalued by the market. It could also signal management’s confidence in the stability of the company and its future profits. Much like dividend distributions, many believe that share buybacks are a responsible way of returning money to shareholders, which can then be deployed elsewhere by investors.
Buybacks, in the US at least, have risen at a faster pace than capital spending in 2018. In fact, it’s the first time since 2007 that buybacks have topped capital expenditure. However, it is not necessarily the case that buybacks inhibit capital spending and investment in R&D. Despite narratives to the contrary, capital spending has continued to grow in the US, and been the dominant use of cash by companies over the past decade.
Share buybacks continue to attract mixed reviews given the potential for their misuse by company executives, to boost short-term earnings – particularly given slower projected earnings expansion this year. However, given the potential for buybacks to also create value over the longer term, the solution may not be to crack down on them altogether but, rather, to address conflicts of interest and introduce greater oversight to ensure that a company’s long-term prospects, and its shareholders, are at the heart of management decision making.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.