PMC Weekly Review - May 8, 2015
A Macro View – Are Corporate Buy-backs Bolstering the Market?
First quarter data was less than upbeat, and April data showed signs of an economic soft patch. The first week of May was no different, with productivity falling, labor costs rising, and employers adding the fewest amount of jobs since January 2014. Adding to negative sentiment, on Wednesday for the opening session of the "Finance and Society" conference in Washington, Janet Yellen, the Chair of the Federal Reserve, stated “that equity market valuations at this point generally are quite high" and that "[t]here are potential dangers there." All this negativity begs the question - why have equity indexes moved to historical highs over the last month?
While there is speculation that central banks’ easing efforts are artificially inflating stock values, there is also speculation that the recent increase in share buy-backs could be doing the same. In fact, the topic has not only drawn attention in the financial media, but also drawn attention in Congress, with Senator Tammy Baldwin and Senator Elizabeth Warren criticizing SEC rules which allow companies to repurchase their own shares. According to data provider FactSet, last year alone roughly 72% of the S&P 500 repurchased equity shares; and since the financial crisis companies have spent more than $2.5 trillion to repurchase their own stock. Goldman Sachs Group Inc. projects that there will be an 18% increase in buybacks in 2015, and that this along with a 7% increase in dividends in 2015 will equate to “$1 trillion of cash to investors this year” (David Kostin, chief U.S. equity strategist at Goldman Sachs).
Just as dividends are paid with company cash, equity shares are repurchased using a company’s own cash. It is for this reason that both are considered a way of distributing earnings to shareholders. However, buy-backs are scrutinized because they can influence stock valuations. That is, share repurchases reduces the number of shares outstanding, which typically increases earnings per share (EPS). However, many forget that this will reduce interest income and earnings. Furthermore, if a firm does not use cash, but rather debt financing, interest charges are incurred, and unless the borrowing rate is lower than the weighted average cost of capital (WACC), EPS will fall. Additionally, buy-backs can influence a firm’s book value. That is, book value per share (BVPS) will decrease if the repurchase price is greater than the firms original BVPS and vice versa. Additionally, worries are also fueled that executives can benefit from buy-backs, as compensation can be tied to stock price or valuations metrics. This could influence an executive to choose a buy-back over a dividend. Overall the concern is that an increase in EPS can in turn raise share prices, and to answer the original question, could prop-up the broad market given the large amount of companies utilizing buy-backs.
Outside of valuations, investors are also concerned that equity share repurchases artificially inflate, or hold up the stock price itself. While equity shares can be repurchased through tender offer, direct negotiation or on the open market, the latter is more widely used, and is of the most concern to investors. The reason open market repurchases are more widely used it that the SEC instituted Rule 10b-18 of the Securities Exchange Act in 1982, which allows a corporation’s Board of Directors to authorize repurchases up to a certain amount over time. This gives flexibility to the corporation’s treasury department, to determine the purchases timing and the purchases price. While there are restraints (the amount cannot exceed 25% of the previous four weeks’ average daily trading volume), companies only disclose total quarterly repurchases, and therefore it’s hard to determine if a company has surpassed this limitation. Furthermore, with the corporation’s ability to dictate purchase price, stock prices can be lifted, or even a floor created (also known as support level), with Goldman Sachs expressing concerns that this “could fuel an extended rally.”
As the S&P 500 Index continues to trade over 2,000, investors will continue to debate why. As previously mentioned, there is speculation that central banks’ easing efforts are artificially inflating stock values, or that the recent increase in share buy-backs could be doing the same. It is evident that buy-backs continue to be a popular source of cash distribution to shareholders, reaching levels not seen since before the financial crisis. We suspect the financial media and the Senate will continue to debate the effects equity stock repurchases have on valuations of stocks, stock prices and the overall market.
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