“The leveraged share buyback game has ended, which also means an end to the phony earnings growth.”
By Wolf Richter for WOLF STREET:
HSBC and Goldman Sachs have now both come out with estimates about the extent of the collapse of share buybacks. So far into this crash, over 50 companies have suspended share buybacks, accounting for $190 billion in cash that is not flowing into the stock market, representing over a quarter of total share buybacks in 2019.
HSBC estimates that over the next two quarters, share buybacks in the US could be cut by $300 billion, meaning $300 billion in “lost inflows” into the stock market.
And more cuts are coming. A note by Goldman Sachs analysts, reported by Bloomberg, added: “Reduced cash flows and select restrictions mandated as part of the Phase 3 fiscal legislation suggest more suspensions are likely.”
And slashing share buybacks would have an impact on stocks, the Goldman analysts said: “Higher volatility and lower equity valuations are among the likely consequences of reduced buybacks.”
Share buybacks – until 1982 a form of illegal market manipulation under SEC rules – have had a massive impact on the stock market on the way up. Last year, companies in the S&P 500 Index bought back $729 billion of their own shares, according to S&P Dow Jones Indices. In 2018, they bought back $806 billion of their own shares. Over the two years combined, that amounts to over $1.5 trillion. Since 2012, share buybacks amounted to $4.6 trillion.
This is cash that became a fresh inflow into the stock market. Most of these shares were canceled after the companies had bought them back. From a company point of view, this money just disappeared.
This huge inflow – this relentless bid by companies to buy their own shares at the highest possible price to drive up share prices further – and the ceaseless hype surrounding it, helped inflate share prices into one of the greatest stock market bubbles ever, including a ludicrous 30% gain of the S&P 500 in 2019 when the economy was already struggling and when actual earnings growth had stalled.
So starting in late February, when the market began its epic crash and the liquidity crunch hit companies because their revenues plunged or vanished due to the lockdowns, the first reaction was to switch into survival mode and preserve cash. Share buybacks incinerate cash. And they’re the first on the cutting block, ahead of dividends.
In addition, there are now rules in the $2 trillion stimulus-and-investor-bailout package that prevent companies from buying back their own shares until a year after they paid off their bailout loans. President Trump himself spoke out several times against share buybacks recently, airing his frustration that the proceeds from the corporate tax cuts of 2017 were in fact, as had been widely predicted, plowed into share buybacks rather than invested in the US to drive the economy forward.
So at least over the near term, the rug got pulled out from under the share buyback scheme.
In terms of the impact of vanishing share buybacks, Chris Wood, global head of equity strategy at Jefferies, said in a note, also reported by Bloomberg, that he saw two problems:
- One, US stocks “began the downturn so overvalued at a record high valuation to sales”;
- And two, “the leveraged share buyback game has ended, which also means an end to the phony earnings growth it produced.”
As companies are laying off millions of people in order to stem the cash outflow, and as their shareholders and creditors are getting bailed out to the tune of trillions of dollars created by the Fed or borrowed by the US government, share buybacks are mostly off the table for now.
Part of the great science of financial engineering, share buybacks have three goals:
- Drive up share prices;
- Conceal from shareholders the costs (via dilution) of stock compensation packages for executives;
- Create “phony” growth in earnings per share. Share buybacks reduce the share count (the denominator of earnings-per-share), thereby increasing earnings per share when actual earnings go nowhere.
But share buybacks come with massive costs that don’t hit home until there’s a crisis: By incinerating $4.6 trillion in cash since 2012, and often borrowed cash – the “leveraged share buybacks” – companies willfully burned up their equity capital and rendered themselves recklessly fragile and overleveraged, and predictably far less able to withstand the next crisis, though they knew perfectly well that there is always a next crisis.
Neither the Fed nor the Treasury can bail out brick-and-mortar retailers. Read… Post-Lockdown New Normal: Many Brick & Mortar Stores Will Not Reopen, CMBS will Default, Mess to Ensue
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