According to Goldman Sachs’s US Weekly Kickstart research booklet, investors are beginning to reverse the long-term trend of rewarding firms spending cash to repurchase shares, as corporate debt levels soar and equity valuations trade close to all-time highs.
This conclusion is based on the performance of Goldman Sachs’ ‘buyback basket’ of stocks, which has returned 5% year-to-date compared to 7% for the S&P 500.
Buybacks are underperforming
The performance of Goldman’s ‘buyback basket’ isn’t the only indicator that shows investors could be getting bored with buybacks. Figures show that buyback executions have decelerated since reaching a record high during the first quarter of 2016.
Share repurchases hit a high of $163 billion in the first quarter, the highest level since Q3 2007. However, since reaching this high water mark, buyback execution has fallen by 18% year-on-year. Buyback authorisations have declined by 31% compared with 2015, although these figures are skewed slightly by several large multi-year programs announced last year by Apple and General Electric.
After adjusting for the most substantial programs, authorizations have fallen by 8%. Still, despite buyback deceleration S&P 500 purchases will rise by 7% for full-year 2016 thanks to modest GDP growth, a surge in buyback activity and $150 billion in unused buyback authorizations. Aggregate S&P 500 buybacks will equal $600 billion in 2016 vs. $561 billion in 2015.
One factor that could be responsible for the slowdown in repurchase activity is stretched valuations. The median S&P 500 stock trades at a P/E of 18.3x, ranking in the 98th percentile since 1976. The S&P 500 index hit an all-time high of 2173 last week. Also, since the start of 2Q, 40% of S&P 500 stocks has reached a five-year high, and almost 60% have hit a 52-week high. Simply put, the majority of equities are extremely expensive, and buyback authorizations should reflect this.
Debt too has reached worrying levels, and it seems as if managements are finally starting to wake up to the risks high levels of debt. S&P 500 net debt/ EBITDA has risen by 32% to 1.4 from 1.0 since start of 2015. Elevated levels of debt and rising borrowing costs may restrain debt-financed buybacks.
Buybacks are falling out of favor, buy dividends
So, it looks as if buybacks are falling out of favor with investors, however, the evidence shows that as buybacks are slowing, investors are increasingly turning towards dividends.
The Telecoms and Utility sectors have been the best performing industries so far this year and Goldman’s ‘dividend basket’ has returned 9% year-to-date compared to 7% the S&P 500. Moreover, dividend stocks trade at a discount to the wider market. Goldman’s ‘dividend basket’ trade at a PE of 15 times versus 17 times the S&P 500.