A Dark Side to the Buyback Boom

'Repatriation' is underway... Corporate America is buying back shares like there's no tomorrow... Echoes of 2007... A dark side to the buyback boom...

Well, it's official...

Following last year's corporate-tax reform, we noted that the law could fuel a big increase in U.S. corporate share repurchases, or "stock buybacks" as they're more commonly known.

In short, the law provided a one-time "repatriation holiday" that allows companies to bring overseas cash back to the U.S. at a lower-than-normal tax rate. This cash can then be used to pay down debt, fund capital expenditures and growth, or – as we predicted would be the case for many companies – fund additional share buybacks and higher dividend payments to investors.

It's still early, but that already appears to be playing out...

According to S&P Dow Jones Indices, share buybacks hit a new all-time record in the first quarter of 2018. All told, S&P 500 companies repurchased $189 billion of shares.

That's up about $50 billion from the fourth quarter of last year, and nearly 10% higher than the previous record set in the third quarter of 2007. And as you might expect, the technology sector – whose largest members are sitting on massive overseas cash piles – accounted for $63 billion, or roughly one-third of the total.

Meanwhile, S&P Dow Jones notes dividends are on pace for their seventh annual record in 2018, and could potentially grow by double-digits for the first time since 2015.

These are impressive statistics...

But this "boom" could have even further to run. As the Wall Street Journal reported this morning...

U.S. companies have brought home only a sliver of their more than $2 trillion in profits stashed overseas, a sign that this year's corporate spending spree on things like [buybacks] is only just beginning...

U.S. companies repatriated roughly $217 billion in the first quarter, according to J.P. Morgan. That equals about 10% of the $2.1 trillion it believes is sitting overseas...

JP Morgan says U.S. companies could eventually bring home more than $400 billion in overseas earnings. What will companies do with all that money? Send it back to shareholders, analysts say.

Regular Digest readers know stock buybacks have been a big driver of higher stock prices over the past few years. So this trend should continue to provide a bullish tailwind for U.S. markets in the near term.

But remember, buybacks are a 'double-edged sword'...

Under the right circumstances – when shares are trading at discount to the value of the business, and the company has the cash to fund them – they can be great for investors. All things being equal, buybacks reduce the total number of shares outstanding, and make each remaining share more valuable.

But this often isn't the case. As our colleague Dan Ferris explained three years ago in the April 13, 2015Digest, just as the most recent buyback boom began...

To do share buybacks right, the first thing a company has to do is hang onto its cash when the stock is expensive. That's hard, because investors will criticize it for holding too much idle capital. Think of how bullish you and everyone else were in late 2007... right before the S&P 500 peaked that October.

Then, when the market finally falls, companies have to be brave enough to step in and start buying their own shares – hopefully at a discount to what the business is worth.

Think of how bearish you were in the spring of 2009, when everyone was scared to death that another Great Depression was coming. Well, the folks running big corporations are human just like you. They bought back their own shares like crazy at the top and bought back very little at the bottom...

S&P 500 companies spent a record of roughly $180 billion on share buybacks in the third quarter of 2007, right as the stock market peaked... At the bottom in early 2009, the same group of companies spent around $30 billion on buybacks.

Again, data suggest this boom could continue awhile longer...

But we'd argue today's environment has far more in common with 2007 than 2009.

Today, we're seeing many companies buying back shares at historically high valuations. And even worse, most – outside of a handful of big tech firms – have been borrowing heavily to do so. As Porter explained in the December 8 Digest...

Across the landscape of American finance, company after company has "levered up," adding trillions in debt to finance share buybacks.

That's the single biggest explanation behind the magnitude, breadth, and duration of this bull market. It will also explain the severity of the bear market that will follow.

American companies haven't discovered the Holy Grail of finance. The leverage we've added over the past seven years will come back to haunt us.

But this isn't even the most troubling part of the recent boom...

It's bad enough that corporate executives have once again become dependent on "financial engineering" – using buybacks to turn debt into earnings growth – to push share prices higher. But a recent study by the U.S. Securities and Exchange Commission ("SEC") found that many have also been using buybacks to enrich themselves, much as they did in the run-up to the 2008 financial crisis. As SEC Commissioner Robert Jackson noted in a speech earlier this month...

When I was sworn in a few weeks after the Trump tax bill took effect, I asked my staff to take a look at how buybacks affect how much skin executives keep in the game... So we dove into the data, studying 385 buybacks over the last 15 months. We matched those buybacks by hand to information on executive stock sales available in SEC filings.

First, we found that a buyback announcement leads to a big jump in stock price: in the 30 days after the announcements we studied, firms enjoy abnormal returns of more than 2.5%. That's unsurprising: when a public company in the United States announces that it thinks the stock is cheap, investors bid up its price.

What did surprise us, however, was how commonplace it is for executives to use buybacks as a chance to cash out. In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement. In fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day. So right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.

And, in the process, executives take a lot of cash off the table. On average, in the days before a buyback announcement, executives trade in relatively small amounts – less than $100,000 worth. But during the eight days following a buyback announcement, executives on average sell more than $500,000 worth of stock each day – a fivefold increase. Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement.

Now, as Jackson noted, this trading isn't necessarily illegal... But that's likely little consolation for these companies' shareholders.

It's one thing if corporate execs are simply bad investors... It's another altogether if they're intentionally using buybacks to cash out at your expense.

New 52-week highs (as of 6/26/18): none.

In the mailbag: It seems paid-up subscriber Charlene P. touched a nerve... and a big worry about share buybacks. Send your notes to feedback@stansberryresearch.com.

"I agree completely with Charlene P. I did without and my family had to make do, for 40 years while we focused on our goal. A decent retirement, a home on the lake (for which we paid cash) Stansberry had quite a lot to do with accomplishing our goals in the Teaching of the financial rules of the road. I learned about investing from my mother (she never was in the investing community), she just inherently knew there was something about investing that would give me a boost.

"Now I'm afraid my family and I are in the cross hairs of social justice warriors otherwise known as lazy ignorant fools who think they can have something for nothing and plenty of politicians telling them they can get it from those of us who worked all our lives to get where we are. Sorry for the rant." – Paid-up Stansberry Alliance member Steve J.

"Charlene P... I could not agree more." – Paid-up subscriber Bruce W.

"I would like to respond to Charlene P. What was the purpose of your mean-spirited comments? Why are you so angry? I know someone who has 4 jobs and is barely getting by. I have another whose house burned down and he lost everything because his insurance company screwed him.

"Most people live in poverty are there because they can't make enough to pay their rent, food, electric, heat, clothing and transportation expenses or they have had a major family illness that wiped away their life savings. It has nothing to do with living beyond their means, spending money on luxuries, being impatient or being lazy.

"The wealth disparity in this country is getting bigger every year because the rich make the rules so they get richer, and the poor get poorer. A couple can both work full time jobs and be below the poverty line. Does that sound fair? You think you've worked hard for 30 years? Try working at a fast food restaurant, do landscaping, or pick fruit. And do it for 50 years.

"Get off your high horse and go volunteer to help some people that have not been as financially fortunate as you, and listen to their stories. I think you may learn something and be thankful that you haven't experienced some horrific event in your life that wiped out your savings." – Paid-up subscriber Brian O.

"I have HUGE Concerns about Corporate stock buybacks! I have noticed that rather than grow earnings by creating better products, adding more services or conducting research and development — essentially, investing in the future ... many of America's biggest companies are actually manipulating earnings and share prices by creating artificial demand for their own stocks by buybacks.

"Once outlawed... stock buybacks are now legal again thanks to rule 10b-18. The SEC is even on record saying that they do not monitor such stock buyback activity to prevent market manipulation. And since 2008, America's largest companies have purchased a mind-boggling $5.1 trillion of their own shares ... so basically, they are the only ones really purchasing stocks. It's the only way they could pump $5.1 trillion into the stock market ... creating the bubble of all bubbles. The CEO's profit in the C-suite but what about us capitalist investors?

"I have heard that a federal agency will be holding a critical meeting on or around the end of this July. I am MORE THAN CONCERNED that the results will put an end to this scheme and take down both the companies and their investors. There will be nobody left to buy stocks and, their artificial earnings will be brought to light. Their real earnings will disappoint ... sending PE ratios back to earth.

"If the Fed ends buybacks where are we as investors going to turn? Commodities, China, etc.? I am very worried about this without a plan in place... Can you help please?" – Paid-up subscriber Stansberry Alliance member Willie B.

Brill comment: We're not sure what you're referring to, Willie. A couple of congressional Democrats have introduced bills to ban or restrict share buybacks, but these bills have little support among lawmakers today.

But you are right to be concerned... As we've noted, debt has funded a significant amount of recent buyback activity.

This is unsustainable... which means this "scheme" will come to an end eventually, with or without government intervention, and the share prices of many of these companies are likely to suffer. Porter highlighted some of the worst offenders in the December 8 Digest.

Regards,

Justin Brill
Baltimore, Maryland
June 27, 2018