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Aon Retirement and Investment Blog

Buyback Bonanza – Short Term Gain for Longer Term Pain

Why have US equities posted a series of record highs when both economic and corporate revenue growth have been mediocre? The growing practice of companies buying back their own shares is a key part of the answer. This buyback bonanza has created significant support for equity prices, but may be delivering near term gains at the expense of longer term pain.

A historic perspective

Dividends used to be the main way companies returned cash to shareholders but there has been a dramatic change in recent times. Dividend payout ratios (the proportion of earnings that are paid out as dividends) have plummeted as companies have increasingly turned to share buybacks as an alternative way to return cash to shareholders. According to S&P, over 80% of S&P 500 companies have bought back shares this year and buybacks have been significantly outstripping dividends for most of the past 10 years.
 

 
Consequently, though dividend payout ratios have been low, when buybacks are included total payout ratios have been much higher. Companies have been using around 85% of their earnings to pay dividends and buy back stock.
 
Buybacks have clearly become an important feature of the equity market environment with both positive and negative implications. Our research comes to a number of major conclusions:
 
1. Companies have the finance and motivation for buyback activity to continue at an elevated level, supporting equity markets in the near term

High cash levels, relatively cheap debt financing and management incentives which are linked to share prices and/or earnings per share (EPS) growth will all encourage buybacks.
 
2. More worryingly, the main source of demand for equities has been from companies themselves - markets have become dependent on corporate buying to support prices

The rest of the market has been a net seller in aggregate, so had it not been for companies buying shares, selling pressure would have surely pushed prices lower.
 


3. While supporting markets in the near term, buying back shares when valuations are expensive is value-destructive in the long run.

Buybacks are beneficial for a company when shares are bought back cheaply below their 'fair value'. However, the opposite is true. Buybacks can have a negative long term impact if they take place when shares are overvalued. Current equity markets remain fully valued on most measures and expensive on others so although high levels of buybacks should continue to support prices in the near term, the longer term impact will be at best neutral, and at worst, value-destructive.

4. Headline EPS growth figures overstate underlying earnings growth due to the impact of buybacks.



By reducing the number of shares outstanding through buybacks, companies can boost their reported EPS growth. Barclays estimate that, on average, S&P 500 companies have benefited from a 1-2% a year EPS growth boost over the past four years as a result of buybacks but in some cases the impact has been much larger. Apple's Q2 earnings increased by around 12% but EPS grew by almost 20% due to buybacks! Analysts often value companies based on their EPS so higher EPS figures can lead to higher share prices. By buying back shares, a company could potentially inflate both its EPS and, as a consequence, its share price.

Indeed, there is an argument that one reason for the popularity of buybacks is that management remuneration packages are often linked to EPS growth. This incentive to pursue buyback policies is unlikely to go away.
 
5. If sustained, current buyback levels could do long term damage to the earnings capacity of listed companies, and with that, long term prospects for economic growth and equity market returns.

By choosing to pay out the vast majority of their profits through a combination of buybacks and dividends, companies are retaining only a small proportion within their business to generate future growth.  If current profitability and payout ratios were to be maintained, then our calculations suggest that companies would struggle to generate much more than 2% earnings growth on a long run sustainable basis. Current buyback policies may lead to near term gains but at the expense of longer term pain.

Our expectation is that as the economic recovery progresses and companies grow more confident regarding the outlook, they will divert cash away from buybacks and towards profitable investment opportunities. However, so long as there are clouds on the horizon, the current buyback bonanza shows no signs of letting up.

6. Outside the US, buyback activity is less prevalent but the scene is set for an increase. Investors in Japanese and European equities look set to benefit, with the UK less impacted.

Buybacks are less common in the UK, where dividends remain the most popular way to return cash to shareholders. We see no reason to expect this to change dramatically in the near term. However, in Europe investors have rewarded those companies engaging in buyback activity with outperformance and against a backdrop of huge uncertainty and weak growth, non-financial companies are likely to come under pressure to return more of their plentiful cash piles to investors. In Japan too we are already seeing signs of a noticeable pick up in buyback activity as the combination of significant cash holdings, low yields and the prospect of higher inflation is incentivising Japanese companies to return cash to shareholders.
 
This is an abbreviated version of a recent research note written by Aon Hewitt's Global Asset Allocation team. If you would like a copy of the original longer research note then please contact your Aon Hewitt consultant.
 
The information contained above is intended for general information purposes only and should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only. 


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