A $200 billion quant fund says one of the biggest concerns about how companies will spend their tax savings is overblown

  • AQR Capital Management, a quantitative-focused hedge fund overseeing $US208 billion, seeks to dispel what it sees as the four biggest myths associated with corporate share repurchases.
  • The firm argues that companies using cash to repurchase stock doesn’t hinder economic growth, as has been suggested in recent weeks.
  • One of the arguments against Republicans’ proposed tax cuts has been that companies will use excess capital to simply buy back their own shares.

To hear detractors of Republicans’ tax bill tell it, the plan as written wouldn’t actually boost economic activity. These sceptics think corporations will simply use the excess capital from tax cuts to buy back their own shares.

And that’s not too far-fetched of an idea. After all, buybacks have swelled during the 8-1/2-year equity bull market, and stock gains have followed in spades.

The conventional explanation for the strength has been as follows: Companies artificially boost their share prices by reducing the number of units outstanding while simultaneously signalling to the market a belief that their shares are attractively priced.

But AQR Capital Management, the quantitative hedge fund that manages $US208 billion, doesn’t buy it. The firm thinks buybacks are misunderstood – and don’t directly drive much share appreciation at all.

AQR has even gone as far as to compile what it sees as the four main myths of share repurchases, which the firm published in a recent research paper titled “The Premature Demonization of Stock Repurchases.” And while the study doesn’t specifically mention the GOP tax plan, it does address worries specifically related to it.

“A common critique is that each dollar used to buy back a share is a dollar that is not spent on business activities that would stimulate economic growth,” a team led by AQR’s managing and founding principal, Cliff Asness, wrote in the study. “Oh, if only it were that simple.”

Here are the four myths:

Myth No. 1: Companies are self-liquidating using share repurchases at a historically high rate

AQR acknowledges that the total dollar amount spent on buybacks is higher than in the past, but it says this “muddles changes in the scale of the economy and changes in the typical balance sheet of firms throughout time.”

The firm points out that the total money spent on buybacks, relative to aggregate market cap, is not at a record. In fact, the measure is far below where it was during the latest financial crisis. AQR also says that, when properly normalized, there hasn’t even been an upward trend in buybacks over the past five years.

Screen Shot 2017 12 11 at 4.24.19 PMAQR Capital ManagementBuybacks as a portion of aggregate market cap haven’t been rising.

Myth No. 2: Share repurchases have come at the expense of profitable investment

AQR says this assertion is “not consistent with either finance theory or an empirical examination of the sources and uses of capital among US corporates.”

The firm stresses that there’s no apparent negative relationship between normalized investment and stock-buyback activity. It also highlights that the two readings have actually been positively correlated lately, with both rising since the financial crisis.

Screen Shot 2017 12 11 at 4.28.25 PMAQR Capital ManagementCorporate buybacks and reinvestment have actually been positively correlated in recent times.

Myth No. 3: The recent increase in stock prices is the result of share repurchases

To disprove this one, AQR computed a rough estimate of cumulative index-level returns using stock buybacks as the only input. The firm found that if every member of the gauge bought back shares in a given year at historically normal sizes, it would account for 1% to 2% of index-level price appreciation. That’s a far cry from the gain of more than 15% for the Russell 3000 index.

Perhaps an important nuance to this point is that while buybacks can’t be fully responsible for the large gains seen in the stock market, they are accretive to a degree.

Myth No. 4: Companies that repurchase shares do so only to increase earnings and thereby ‘price’

For this one, AQR points out that while buybacks reduce share count, the depletion of cash to buy back those shares is negative for earnings. “Only if the cash that is used for share repurchases is truly idle (sitting in the chairman’s desk drawer) would we agree that share repurchases increase EPS,” Asness wrote.

Going off AQR’s logic, investors shouldn’t be worried about the tax plan’s massive windfall being misused. Assuming companies realise that buybacks aren’t directly responsible for share gains, they will theoretically be more likely to spend money on capital expenditures, or capex, and corporate reinvestment – the activities most closely tied to economic growth.

And based on recent equity-market performance, companies should already be favouring reinvestment to share repurchases anyway.

From the beginning of 2016 through October, a Goldman Sachs-curated basket of stocks spending the most on capex and research and development has beaten a similarly constructed index of companies offering high dividends and buybacks by a whopping 21 percentage points. That outperformance totaled 11 percentage points in 2017 alone, according to the firm’s data.

Goldman’s data-backed argument that companies should be reinvesting, combined with AQR’s myth-busting around the use of buybacks, should give corporations all the information they need to use tax cuts in a way that would help the overall economy.

But will they? That’s another discussion entirely.

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