A lot of strange things are happening in the market these days.
For example, it used to be that if you piled into the top ten stocks big hedge funds were in, you could make a nice profit in the stock market. Now that has reversed itself, and overall it seems stock pickers need to be more careful now, and everyone is talking about how they have to find “quality.”
Now it looks like investors are deciding for the first time since 1995 that “quality” does not include companies that engage in share buybacks. After a record first quarter of 2016, buyback activity has fallen by 18% in the second quarter, Goldman Sachs noted over the weekend, and that may be because investors don’t really like buybacks anymore for some reason.
“However, so far in 2016 investors have penalised firms that executed buybacks while rewarding firms with high dividends and high capex. Low interest rates and uncertain global growth prospects have led investors to high dividend yielding sectors such as Telecom (24% YTD) and Utilities (22%),” Goldman Sachs analysts wrote.
Don’t wait up
This is a significant reversal. Since 1995 companies that bought back stock have outperformed the S&P 500 by about 4%. Now Goldman is seeing just the opposite.
“Our sector-neutral basket of stocks with the highest capex and R&D (GSTHCAPX) has returned 12% in 2016 vs. 7% for the S&P 500. In contrast, our basket of stocks with the highest trailing four-quarter buyback yields (GSTHREPO) has lagged the S&P 500 by 280 bp YTD (5% vs. 7%),” according to the Goldman note.
Goldman believes that this is happening because investors are scared of this low growth environment, and they’re opting for consistent, lower, bond-like returns over the one-time pop of a buyback.
A few caveats here. This isn’t to say 2016 won’t be a big year for buybacks, thanks to a huge first quarter and $150 billion in authorizations still lying around. The bank thinks we could end the year with a 7% increase over last year in the overall value of buybacks.
But this environment is still strange. Usually buyback activity picks up in August, and that’s just not happening right now. Balance sheets are getting weaker and corporate debt is piling up high, meaning corporations won’t be in a position to buy back as much stock in the future if these trends continue.
“By the end of next week, more than 85% of S&P 500 firms will have exited their blackout windows and will be able to resume discretionary repurchases. However, lower YTD authorizations, poor relative performance of high buyback firms, and high stock valuations suggest that buyback activity is unlikely to experience the traditional acceleration in 2H,” said Goldman.
That thing we talked about last year
Corporate buybacks have recently been the biggest driver of demand for US stocks, so none of this is good for stock prices overall.
That said, it’s also worth considering which companies could get hit the hardest. About a year ago, all of Wall Street was talking about the idea that the big conglomerates that have been cobbled together through mega mergers and acquisitions over the years, eschewing dividends in favour of share buybacks, were about to have a rude awakening.
The idea was posited by James Litinsky of JHL Capital at the Grant’s Interest Rate Observer conference last fall. Basically, he said conglomorates, which he called “platform companies,” that had boomed by taking on a load of debt to do deals (he named Valeant Pharmaceuticals and Anheuser Busch as two examples) were about to go bust.
Too much debt combined with higher interest rates would force big conglomerates to stop doing deals and buying back stock. Without that, and without organic growth, these companies wouldn’t look attractive to shareholders anymore.
This isn’t necessarily happening yet, but this buyback slowdown is a sign that it’s coming. Higher interest rates aren’t here yet, but anemic earnings and a slower dealmaking environment certainly are.
So it looks like we’re going to find out if these platform companies have what it takes soon enough.
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