Deutsche Bank’s controversial bull David Bianco has another reason to buy equities in his latest note to clients: share buybacks.He writes that high cash balances of non-financial corporates, robust free cash flow measures and “abundant unused debt capacity” signal that “this vanishing of equities will accelerate despite higher dividend payout ratios,” driving a reduction in supply in the market for shares and thereby putting upward pressure on prices. And these buybacks could be further spurred if Congress passes corporate tax reform (reasoning included below) that allows companies to easily repatriate their overseas cash balances.
This chart shows the protracted decline in shares outstanding that Bianco says will now accelerate:
Photo: Deutsche Bank
Bianco writes that cash levels as a percentage of market cap are 60% higher today than in the “heydays” of the 1990s:
We expect the S&P 500 to generate over $500bn in surplus free cash flow in 2012 and 2013. This is about 4% of market cap today compared to 2.5% in late 1990s. In absolute and relative terms, this potential for equity market inflows from corporate treasuries far exceeds the $200bn in annual equity mutual fund inflows during the late 1990s.
A lot of this cash is, as we mention above, overseas, and companies have no reason right now to bring it back. Therefore, corporate tax reform of some sort would have to happen in order for this to work.
Bianco thinks this is a possibility:
While this is clearly an election issue, we think a growing number of politicians recognise the growth benefits of not penalising companies for bringing cash back home. Moreover, there is global competitive pressure to converge corporate tax rates anyway.
Finally, Bianco sees a little bit of extra juice that could be squeezed out of changes in the capital structures of low-debt companies that have access to very cheap financing while interest rates are held down:
Net debt to market cap at the S&P 500 is currently 15%, below its 1990s average of 30% despite significantly lower interest rates. If the S&P non-financials were to raise its net debt to market to 25%, which would certainly not be excessive leverage, it would give the S&P close to $1 trillion in unused debt capacity. If this was used to repurchase shares, it would raise S&P 500 EPS by $7 or by 6.7%, assuming an after tax cost of debt of 2.5%.
“At certain levels, cash can become a valuation liability and debt an asset,” writes Bianco. All signs seem to point to more buybacks. And like we wrote earlier, the shrinking supply could put upward pressure on prices.