- In 2014, the S&P 500 Index’s dividend (1.9%) + buyback (2.9%) yield = 4.8%, but this yield was not realized by investors.
- As in most years, in 2014 issuance of new shares—for management compensation, new investments, and funding mergers and acquisitions—exceeded buybacks.
- The dilution rate for the U.S. equity market in 2014 was 1.8% compared to the historical dilution rate of 1.7% over the 80-year period from 1935 to 2014.
- U.S. equity investors in aggregate—contrary to appearances—have not realized a benefit from the recent spate of stock repurchases.
Like travelers in the desert searching for water, we survey the parched investment landscape looking for high-yielding assets to quench our thirst for investment income. Shimmering on the barren surface of zero real yields, is that a lush garden of stock buybacks that we spy on the horizon? We examine the impact on investors of the recent increase in buybacks using an approach introduced by Bernstein and Arnott (2003).
In 2014, buybacks represented 2.9% of the S&P 500 Index’s market capitalization. When this distribution of cash is added to the 1.9% dividend yield of the S&P 500,1 it produces a dividend-plus-buyback yield of 4.8%. For yield-thirsty investors, this combination appears to be an oasis in the capital market desert. To be that oasis, however, buybacks must not be diluted by net new issuance. We scour a range of sources to tally new issuance, discuss why companies issue new stock, and explain the possible dilutive impact of this new issuance.
Who’s Buying Back Stock?
In 2013, S&P 500 companies, the largest in the United States but nonetheless a subset of the market, spent $521 billion on buybacks. In 2014 that amount rose to $634 billion and moved higher still to $696 billion when total repurchases by all publicly traded companies in the U.S. market are included.2 The top 15 companies by repurchases are listed in Table 1.
[drizzle]Six of the 15 top companies are in the tech sector: Apple, IBM, Intel, Cisco, Oracle, and Microsoft. Combined, these six huge cash-flow-generating companies are responsible for 14% of all public company buybacks in 2014. Apple alone bought back $45 billion of its stock, nearly equivalent to the annual gross national product of Costa Rica, a country with a population of 5 million.
In order to ascertain the true impact of a company’s repurchases on its shareholders, we need to determine the amount of stock a company issues over the same period it is buying back its stock.
Lifting the Veil on New Issuance
Companies do not make it easy for investors to know how much new stock they are issuing. Finding these numbers takes investigation and research, lifting the veil on a company’s true financial operations. Our first path of approach is a company’s cash flow statement. The financing section of the statement captures the securities sold to raise capital, transfers of different classes of shares into common stock, and the exercise of options and warrants. Table 2 lists the companies with the largest stock issuance as reported in their respective cash flow statements. Total issuance reported for the 2014 fiscal year equals $257 billion dollars, 1% of market capitalization.
Interestingly, 5 of the companies in the top 15 buyback list (Table 1) are also in the top 15 issuance list. These five companies are highlighted in Table 2. Delving deeper into these companies’ cash flow statements we see that they engaged in significant options-based compensation programs.
Stock Options for Management
The 5 companies in the top 15 buyback list that are also in the top 15 issuance list are Cisco, Oracle, Johnson and Johnson, Wells Fargo, and Merck. Although all five have massive buyback programs, the programs coincide with significant share issuance. Largely responsible for this overlap is employee compensation, in particular, stock options.
When management redeems stock options, new shares are issued to them, diluting other shareholders. A buyback is then announced that roughly matches the size of the option redemption. This facilitates management’s resale of the new stock they were issued in the option redemption. Buyback? Not really! Management compensation? Yes.3
Because the stock options a company issues its management dilute the value of its stockholders’ shares, companies often repurchase their stock to offset this dilutive effect. The net impact is a transfer to management of more of a company’s cash flow than is reported as compensation on the income statement. Irrespective of the intent of the company to reduce the dilutive impact of its options-based stock issuance with buybacks, the reality is that the dilution is not always totally offset.
But We Must Lift the Veil Higher…
Upon closer examination, we find that the cash flow statement often fails to report the majority of a company’s stock issuance. How do we know this? We compare the market capitalization of a company at the end of the year to its market capitalization at the beginning of the year, adjusted for the change in the company’s stock price. If the price is up 10% and market capitalization is unchanged, there must have been 10% new share issuance. This analysis allows us to determine the amount of a company’s stock buybacks or issuance. We then follow a thorough process of fundamental research into each company’s corporate actions as described in its press releases and by the financial media to determine the source of and reason for the new issuance unexplained by the cash flow statement.
Aggregating the equity of all publicly held U.S. corporations, we find that U.S. companies issued stock equal to $1.2 trillion in 2014. Whereas part of this aggregate market issuance was in the form of initial public offerings, far more stock was issued by existing companies, the largest of which are listed in Table 3.
Why are companies issuing such large amounts of stock? In addition to stock options for management, we find that a substantial amount of new issuance is to support companies funding merger and acquisition activity. With so much new issuance, the potential benefit of stock buybacks may not be realized by the investor.
Currency for M&A
Companies are issuing new shares to fund merger and acquisition (M&A) activity. Like a corporate currency, companies print new stock, beyond the issuance that’s reported on their cash flow statements, to purchase other companies. These stock-for-stock transactions are not always reported as cash flows; neither are they necessarily nondilutive. Examples of such issuance in 2014 for M&A purposes are Kinder Morgan consolidating a few of its subsidiaries, Verizon acquiring Vodafone’s U.S. operations, and Facebook acquiring Whatsapp.
The first two examples are of nondilutive transactions. Kinder Morgan was retiring the stock of subsidiary companies and concurrently issuing new stock of the parent company. The net effect is that no new stock was added to the market in aggregate. Similarly, acquisitions of one public company by another, such as Verizon acquiring Vodafone’s U.S. operations, are not dilutive to the aggregate public market. Because these types of transactions are accounted for in the $1.2 trillion of stock issuance reported in Table 3, this measure effectively overstates issuance in terms of the aggregate market.
The acquisition of Whatsapp by Facebook, however, is an example of a transaction in which net new shares were