<June 28, 2024>
While attending Stetson University in 1992, I enrolled in an investment class taught by a small cap portfolio manager. Unlike most investment courses at the time, the professor, or manager, encouraged students to seek and take advantage of market inefficiencies.
One of the inefficiencies we studied was related to stock buybacks. We learned that large stock buybacks often resulted in above average equity performance. While we were introduced to other inefficiencies, buying back stock below a business’s fair value resonated with me. In fact, after graduating and becoming an equity analyst, I screened for companies with aggressive buyback programs. I discovered companies with buybacks tended to have higher free cash flow and stronger balance sheets. In effect, companies with buybacks were also higher quality businesses.
As the years went by, the number of companies announcing stock buybacks increased. Eventually buybacks became as common as dividends! As buybacks spread, their purpose seemed to shift. Instead of buying back stock to increase the per share value of a business, buybacks were often being used to manufacture EPS growth and offset the dilution of equity compensation plans. Further, a growing number of companies began taking on debt to fund buybacks, something that seldom occurred earlier in my career.
Stock buybacks remain extremely popular today. According to Goldman Sachs, buybacks of S&P 500 companies reached $815 billion in 2023 and are expected to exceed $1 trillion in 2025!
Several analysts have pointed to the growth in passive investing as a reason the current market cycle has been so resilient. While price-insensitive passive flows are likely boosting equity prices, we believe buybacks may be having an even greater impact. According to the Investment Company Institute (ICI), passive domestic equity funds had net inflows of $267 billion in 2023. While impressive, these flows are well below the $815 billion used by S&P 500 companies to repurchase stock.
In the article, “Buybacks Are Back, With Meta, Apple Leading Spending Spree”, The Wall Street Journal notes S&P 500 companies bought back $182 billion in stock in the first quarter, up 16% from last year. Further, 443 of S&P 500 companies have announced buyback plans in 2024 versus 378 a year ago. According to the article, the rise in buybacks is a result of rising confidence among business leaders, a resilient economy, and improving profits.
Corporate profits have been increasing over the past several years, with a noticeable jump in 2021. We believe the step-up in profits in 2021 was caused by the meaningful increase in government spending related to COVID. With spending remaining elevated, fiscal deficits continue to stimulate the economy and corporate profits, providing companies with the cash flow and confidence to buy back stock. It’s a cycle few want to end. Inflated fiscal deficits, inflated profits and buybacks, and inflated stock prices—keep it going!
To keep it going, the U.S. government will need to find a way to fund its deficit spending. That of course means more debt or debt monetization. The current debt-dependent cycle has many similarities to the cycle that ended in 2008. However, instead of mortgage debt, the current cycle is being boosted by growth in government liabilities. Similar to mortgage debt growing from $6.8 trillion in 2000 to $14.6 trillion in 2007, U.S. Federal Debt has more than doubled this cycle from $11.5 trillion in 2009 to $34 trillion in 2023! With debt and interest costs soaring, keeping the current profit and buyback boom going is becoming increasingly challenging and expensive.
For individual companies, it’s also very important to keep the buybacks going. Apple Inc. (symbol: AAPL) is doing just that with its record $110 billion buyback announced on May 2. While the headline number is impressive, the buyback program represents only 3.4% of Apple’s $3.2 trillion market capitalization. Regardless, since the buyback was announced, Apple’s stock has soared 23%, adding $525 billion in market capitalization!
Investors celebrating Apple’s buyback often point to its large cash balance as a funding source, but rarely discuss the other side of its balance sheet. As of March 31, 2024, Apple’s current assets (including cash) were $128.4 billion versus current liabilities of $123.8 billion, equaling an unimpressive current ratio of 1.04x. And while Apple also has $95.2 billion in non-current marketable securities, these assets are mostly offset by $91.8 billion in debt. So yes, Apple has billions in liquid assets, but on a net basis, its balance sheet isn’t bulging with excess capital. Moreover, with its current buyback program exceeding 2024 profit estimates, we expect Apple’s balance sheet will lose more of its shine later this year. Nevertheless, Apple appears committed to keeping its buyback program going, even as its valuation (P/E) has more than doubled over the past decade.
There is a growing list of companies that want to keep it going but can’t. They are companies that have already played their balance sheet card to fund buybacks and no longer have excess capital to repurchase shares. Big Lots (symbol: BIG) is a good example.
Similar to Apple, Big Lots was an aggressive buyer of its stock over the past decade. Buybacks peaked in its fiscal year 2022 as consumers spent their COVID stimulus checks and profits boomed. Unfortunately, the good times didn’t last as consumer discretionary spending faltered and earnings declined. After spending over $1.6 billion on buybacks since 2015, Big Lots suddenly found itself in a liquidity crunch, selling warehouses and entering sale leasebacks to raise capital. Currently, with a stock price near $2 and market cap under $100 million, shareholders surely wish the company didn’t spend so aggressively on stock buybacks.
With the stock market trading at record highs, corporations are aggressively buying back stock. Some consider the current level of buybacks as a sign of confidence. Given valuations, we view it as a sign of capital misallocation and profit extrapolation. In our opinion, the fuel necessary to maintain corporate profitability—deficit spending—will ultimately be cut off by unmanageable levels of debt and rising interest expense. Like past cycles built on debt, once credit growth slows, so will profits and the capital necessary to fund buybacks. After spending trillions on buybacks, we expect many companies that extrapolated this cycle’s inflated profits and easy credit will be unprepared. Without a rainy-day fund and desperate for capital, they’ll likely look back with regret as their names are chiseled into the buyback wall of shame.
Eric Cinnamond
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Definitions:
Free cash flow: the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets.
EPS: acronym for earnings per share.
Market capitalization: represents the total dollar market value of a company's outstanding shares of stock. Shares outstanding multiplied by stock price.
Price-to-earnings (P/E) ratio: measures a company's share price relative to its earnings per share (EPS). Often called the price or earnings multiple, the P/E ratio helps assess the relative value of a company's stock.
Current assets: a balance sheet line item listed under the Assets section, which accounts for all company-owned assets that can be converted to cash within one year.
Current liabilities: a balance sheet line item listed under the Liabilities section, which accounts for short-term financial obligations that are due within one year.
Current ratio: a liquidity ratio that measures a company’s ability to pay current, or short-term, liabilities (debts and payables) with its current, or short-term, assets, such as cash, inventory, and receivables. The ratio is calculated: current assets/current liabilities.
Non-current marketable securities: Marketable securities that have a maturity date greater than one year.