Why the Wave of Stock Buybacks in 2018 May Be Even Better Than Expected

March 13, 2018 by Jon C. Ogg

Source: Thinkstock
When it comes to pleasing investors, companies have multiple avenues outside of simply meeting earnings expectations. They can grow their businesses organically. They can grow the business via acquisitions. But the two areas that can complement any growth strategy are stock buybacks and dividends. Now throw in tax reform, under which billions upon billions of dollars are being repatriated.

Then there is the more direct side of tax reform. The corporate tax rate has dropped from a high of 35% to a much more globally competitive 21%. What this does for companies is to allow corporate managers to allocate an additional 14 cents of every gross dollar in earnings to reward shareholders.

The year 2018 is already turning into a major earnings growth year. It’s also becoming the year of even more aggressive shareholder returns. Dividends already have been raised by many key companies, and now the wave of corporate stock buybacks is increasing despite the stock market being within 5% to 10% of recent all-time highs.

Many economic, political and social critics and pundits have noted that companies should not be using their newfound cash savings for stock buybacks. After all, if the market is at all-time highs then it must mean companies are overspending on their own shares. This makes sense in a three to five-second soundbite, but it completely ignores why certain companies in certain sectors may want to buy back their own stock now — and why some companies almost have to pursue buybacks at this time.

At the end of December and the start of January, the stock market just could do no wrong. Then came the selling at the end of January into the first 10 days or so of February. All of a sudden many stocks and sectors were down 10%, 15% and even 20% from their highs of January or of 2017.

Buybacks are not a new strategy, but they are continuing at a broader and deeper pace than many market participants have expected. In fact, outside of the growth of mutual funds and ETFs, companies have been among the most aggressive in stock buying. Since the end of the financial crisis, S&P 500 companies have repurchased more than $4 trillion worth of their own shares. Measure that up against a Thomson Reuters figure for the entire market cap of the S&P 500 being $24.9 trillion.

Goldman Sachs Group Inc. (NYSE: GS) released a recent strategy report talking up corporate buybacks. And they may know a thing or two since many corporations use Goldman Sachs as their personal stock trading desks for those stock buyback plans (and many executives and insiders use them for insider buying and selling transactions).

Neil Kearns is head of the Goldman Sachs corporate trading desk. He has outlined that companies have been rather aggressive in buying back shares of their own stock. According to Goldman Sachs, corporate buyback activity picked up during the sell-off. Kearns even pointed out that the trading desk sees more interest in corporate stock buybacks when markets exhibit high volatility.

Several other issues were pointed out as well. Kearns pointed out recent trading desk activity by saying:

Stock buyback activity is also highly correlated to the broader market volatility, so many companies used last month’s market correction as an opportunity to get a head start on their buyback program objectives for the year. … Companies have typically taken advantage of short-term market dislocations by increasing their pace of activity at lower price levels, recognizing that for quite a number of years now, these pullbacks have been limited in occurrence and duration, as equities have continued to march higher.

The research team at Goldman Sachs recently raised their internal expectations for buybacks in 2018. S&P 500 companies are now expected to increase total cash spending by 15% to $2.5 trillion, with a 23% jump in share buybacks to $650 billion. That was driven by tax reform and also driven by the recent market correction.

And Kearns thinks that investors should expect buybacks to continue based on historical metrics the last time there was a corporate tax holiday and added in the economic picture today. He said:

When we analyzed the last tax holiday in 2004, for example, S&P 500 buyback execution rose by 84 percent in 2004 and 58 percent in 2005. Companies are also operating in an improved business climate. The economy is strengthening, corporate earnings are expanding and businesses are generating more free cash flow. In addition, any company that isn’t actively allocating its cash effectively faces the wrath of disgruntled shareholders over capital management, and the potential unwanted attention of the activist community.

Canaccord Genuity also has pointed out how strong buybacks are likely going to come in above expectations. On February 20, asset class strategist Brian Reynolds said:

Buyback totals for the fourth quarter, which will be officially tabulated next month in the Fed’s Flow of Funds data and then by S&P, seem to be coming in much higher than our estimate of $109 billion. We have tabulated the share count data for the companies in the S&P 500 that have reported and multiplied that count by an average share price. Though there are still about 10% of firms whose share count data Bloomberg does not have yet, the results so far are prompting us to boost our fourth quarter estimate to $165 billion, which would exceed the $161 billion high for this cycle set in the first quarter of 2016 following the oil price panic.

This surge would explain much of the increase in stock prices in the fourth quarter. Normally, quarterly swings in buyback growth are not material, but this one appears to be so large that it is. If history is a guide, then the buyback acceleration also likely contributed to the stock price rise in January. The Wall Street buyback desks likely took their foot off the gas when the February stock pullback began but are likely picking up the pace now.

24/7 Wall St. has paid close attention to the raw number of stock buybacks that were noted in the wake of December’s tax reform passage and into the start of 2018. In fact, 13 recent dividend hikes and buybacks were simply too large to ignore. And even in December, 20 companies added in a whopping $100 billion in total buybacks.

Warren Buffett also has praised stock buybacks in the past. He has preferred to make acquisitions for Berkshire Hathaway Inc. (NYSE: BRK-A), but he also previously pointed out that buybacks increase the pool of earnings for shareholders on a per-share basis.

It’s easy to say that companies should not buy back stock at all-time highs. Yet, many of the companies that have been leading the stock market and the beloved Nasdaq ever higher pay no dividends or have no buyback plans. Companies like Alphabet, Facebook, Amazon, Netflix and even Buffett’s Berkshire Hathaway are effectively out of the stock buyback and dividend game. That’s more than 10% of the entire value of the S&P 500 that isn’t even participating in that game.

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