I recently received a research note from John Mauldin, in which he writes that “profits are the mother’s milk of economic, stock market and portfolio growth” and that “nothing good happens unless there are profits, and lots of them”. I think this is the perfect quote to open this month’s commentary with.
Strong profitability and sustained operating cash flows are absolutely vital to both distributing wealth to shareholders, and achieving positive asset market performance. At the time of writing, Q3 2016 earnings data was being released with more than half of the S&P 500 index having already reported its results. Following quite a negative period, the most recent earnings have been better, with earnings per share (EPS) growth expected to be positive, if only just (+1% year-on-year growth). These releases are important, as aggregate profitability and cash flow generation are the two key factors effecting index returns.
How should cash flow be spent?
Looking at data relative to the non-financial members of the S&P 500, we can establish what firms do with their cash flows. Over the past 12 months, US companies generated approximately $1.3trn in operating cash flow. This has been absorbed by two traditional uses: re-investment in the business (approximately $1trn), and dividends to shareholders (approximately $0.3trn). So far so good. It is also important to note that an additional $0.4trn has been raised through bond and loan borrowings, and spent on equity buybacks. Although not new, the practice of a company buying back its own equity in the open market is becoming increasingly common.
So why are companies engaging in buyback purchases ratherthan re-investing in their businesses? Buybacks have always been available to companies as a potential use of cash in the absence of business projects capable of delivering an attractive enough return on capital. In addition, over the last 20 years companies have been buying back their shares to offset new equity issuance, as share-based compensation packages were introduced.
A third reason relates to the optimization of their capital structure. It can be cheaper to have a larger portion of the enterprise funded by cheap debt rather than by equity. This also helps avoid excessive dilution for shareholders. A fourth reason – perhaps less noble, more selfish and somehow associated with the increasing short-term nature of capital markets – relates to company management doing “whatever it takes” to meet performance objectives. In fact, through buybacks, a deequitization process has begun.
The number of S&P 500 shares outstanding is at $8.6bn today versus $9.3bn ten years ago. This leads to better ‘per-share’ metrics, as management is able to deliver a higher EPS to shareholders. Substantial purchases of its own stock might also lead to better equity market performance, particularly when we consider that in the current low yield environment, any enhancement to the payout policy of a company is likely to underpin the share price.
Good, bad or ugly?
Looking back to our recent statistics, a hefty $450bn (net of new issuance) is spent by S&P 500 companies on corporate equity buybacks. Are buybacks, which compete with capex and dividends as a use of funds, affecting them negatively? Should the volume of buybacks be considered excessive? Is debt a sustainable channel through which to finance this practice?
Firstly there is no evidence that buybacks are crowding out other uses of corporate cash flows, such as capex and
dividends. In the US, capex as a percentage of cash flow sits just above 50%, in line with historical trends. Dividends, as a percentage of cash flow, are just above 20% and also on trend.
Our conclusion is that both capex and dividends have not yet been impacted by the surge in buybacks. An additional question relates to the size of buybacks. In a historical context, the $450 billion trailing 12 months is a very high absolute number. The previous peak in prices was reached in Q4 2007, before falling to its lowest value in Q2 2009. This was definitely not great market timing by CEOs who seemed to be pro-cyclical buyers, rather than counter-cyclical buyers.
A third consideration relates to the financing source of buybacks, which is debt for a large number of companies. As a principle, a company should never distribute wealth to shareholders that it has not generated itself. In this respect, if capex and dividends absorb all of earnings/cash flows generated by the firm then no extra wealth should be distributed. As of today, US companies as an aggregate are outspending their cash flow generation by a record amount. This is neither healthy nor sustainable.
Previous peaks were reached in early 2009 and mid-1999, and in both cases preceded an economic recession and major market retracement. This is certainly not a good omen. Financing buyback activity through debt may lead to excessive leverage. In the past few years, with debt issuance growing at an annual run-rate of 20% and profitability stagnating, key ratios such as debt/EBITDA and interest coverage have been deteriorating (leverage has moved from 2x to 2.5x and coverage from 10x to 8x). Leverage cannot be stretched further, as certain thresholds have been reached, posing a challenge to the credit quality of S&P companies. This situation is not sustainable – the blanket is too short. Either corporate earnings will need to improve or buyback programs scaled back. Leverage also makes buyback programs vulnerable, in the case of a tightening of borrowing terms, due to fears of a recession or because of monetary policy tightening. In this scenario, buybacks will also need to be reduced.
If buybacks were to slow down because of balance sheet considerations, or due to an increase in the cost of funding,
repercussions would be felt in equity markets. In 2016, buybacks are going to be the largest single source of equity
demand for US stocks. For many years, we have been able to observe how significant changes in the volume of buybacks have subsequently impacted on equity markets.
Cash rich corporates
This might seem a bleak picture, but we shouldn’t despair just yet. Not all companies suffer from the issues I describe. In terms of market cap, excessive leverage is particularly evident in smaller companies, but less of an issue for large companies who, as the most cash rich, are in the best position to sustain their buyback programs. From a sector perspective, serious cash flow issues relate to the Energy, Industrials and Consumer Discretionary sectors. Whereas Healthcare and IT are cash flow rich sectors that are less likely to struggle maintaining their current repurchase levels. One should also remember that large companies in the Healthcare and IT sectors have significant sums of offshore cash on their balance sheets, which is, therefore, currently trapped abroad. Given that both US presidential candidates are interested in initiatives to unlock and repatriate such cash, the potential for it to be used on US capex, dividends and buybacks should not be dismissed.
It’s the profits, stupid!
Future trends will be determined by corporate profitability and cash flow generation. There are two short-term factors to observe: one is the price of crude oil, and the other the value of the US dollar.
Improvements in extraction technology are enabling exploration and production companies to produce oil at an
increasingly lower cost, particularly in the US. These lower supply costs will cap any further rally in the oil price. The
inability of OPEC and non-OPEC countries to reach an agreement regarding a supply reduction plan will, however, keep oil flowing. In North America, it is becoming evident that many distressed producers, including those who have already filed for Chapter 11 protection, continue to extract oil from the ground for cash. Therefore, in the absence of a shock, it is highly unlikely that the price of oil will exceed $55-$60 per barrel. While all this still allows for a recovery in the profitability of the energy sector, it will cap future EPS growth.
A stronger US dollar would impact negatively on S&P 500 earnings. It would suffer from both its exposure to earnings denominated in foreign currency, and through a diminished international competitiveness. It goes without saying that future trends in monetary policy will therefore play a key role.
In addition to these short-term drivers, there are a few longterm trends to keep in mind. First, US profit margins have most likely peaked and may well start to slowly decline. This will be a gentle but inevitable development. Items determining this trend will include higher labour costs, higher effective taxation and higher interest rate charges. These increases, although slow and gradual, will become a drag rather than a contributor to profits growth. It is also possible that we have experienced peak globalization. The world seems to be increasingly focused on national interests and protectionist policies, and after having been a tailwind for global profits, global trade might well become a headwind.
The current pace of buybacks is unsustainable. In the scenario that seems to be developing, the environment supporting high profits and cheap financing may well deteriorate. For many companies it is likely that there won’t be enough disposable cash flow or cheap sources of financing for buybacks. Like a blanket that is too short to cover us from our neck to our toes, profits and cash flows are not enough to cover firms’ outlays on capex, dividends, and buybacks.
Given the US presidential election, allow me to pay tribute to Thomas Jefferson and use one of his quotes as I reach a
conclusion on US buybacks: “Never spend your money, before you have it”.
Considering this, we retain a neutral and cautious stance on equities. Within that, our preference is for EM Asia and Japan. In equities, we also recently reaffirmed our view supporting ‘value’ as a style. In our multi asset strategies this has been expressed through an exposure to European and Japanese banks. We continue to consider ‘quality growth’ and many of the ‘bond proxies’ as too expensive.
One of our preferred positions remains US high yield, as a conservative way to benefit from positive, albeit moderate,
growth dynamics in the US.
Marino Valensise is head of Multi Asset at Barings