Artemis Vega Fund commentary for the month of December 2015, titled, “The Incredible Shrinking Stock Market.”
The Incredible Shrinking Stock Market
“We frontloaded a tremendous market rally to create a wealth effect … The Federal Reserve is a giant weapon that has no ammunition left.” — Former Dallas Fed Governor Robert Fischer (January 2016)
The stock market is shrinking… literally. Since 2009, US companies have spent over $2 trillion buying back their own stocks with the majority of those purchases financed by debt issuance. Large capitalization companies are issuing historically high levels of corporate debt at ultra-low rates, and instead of hiring workers or investing in R&D, they are using the capital to buy back their own shares. Share buybacks do nothing to help fundamental growth rates of businesses; however, they do reduce the number of shares outstanding, artificially boosting earnings per share, and hence reducing price-to-earnings ratios, and therefore helping to boost share prices. A majority of S&P 500 companies use EPS growth targets (rather than sales or operating growth) as a means to evaluate executives for the purposes of stock option payouts. As a result, there is ample incentive for managers to use buy-backs to manufacture EPS growth rates, even if the company isn’t actually growing it core business. For the first time in history, companies in the S&P 500 index spent more than their entire annual operating earnings on share buybacks and dividends.
The buyback craze generates a floor underneath markets, artificially supports earnings, lowers volatility, and represents a wealth transfer from investors to the corporate elite. Empirically, share buybacks have had a tangible effect in shaping the dominant mean reversion characteristics of the current volatility regime.
Share buybacks, in and of themselves, are only a tool and are neither good nor bad. When used correctly they are an effective method for management to add shareholder value by purchasing shares below their intrinsic value. “Below intrinsic value” are the operative words, because if a company is buying back shares at above the intrinsic value of the business it is against the interests of long-term investors. Today, ultra-low interest rates have enabled managers to game the system by using leveraged share repurchasing programs to engineer higher earnings to get fat bonuses regardless of intrinsic value. Unable to generate organic revenue growth by running their core business, corporate CEOs have turned to financial engineering to ensure their bonus triggering EPS targets are met. This was not the intended purpose of low interest rates. In the current bull market, share buybacks have dwarfed the amount of corporate monies spent on research and development, property plants and equipment, and new hires. Instead of contributing to the intrinsic growth of a business, this form of financial engineering is merely a means of ‘gaming’ valuations. It is a wealth transfer from long-term investors to corporate executives… and the net result is a bubble in both equity prices and corporate debt.
The later stages of the 2009-2015 bull market are arguably a valuation illusion built on artificially engineered EPS growth. For evidence, consider that RBC Capital Markets concluded that buybacks accounted for 25% of annual S&P 500 earnings growth between 2012 and 2014 and close to 50% of the EPS growth in 2015. According to a Deutsche Bank study, absent share buybacks, the S&P 500 would have experienced negative EPS growth in 2015. Historically buybacks peak right before market crashes, and prior to today’s peak, 2007 represented their former all-time high.
Share buybacks financed by debt issuance create the illusion of value. When a corporation issues debt to buy back shares it artificially engineers higher earnings per share by removing the number of shares outstanding. The technique optically reduces the price-to-earnings multiple (“P/E Ratio”), and makes the corporation riskier by adding debt, but does nothing to promote the organic growth of the business. Naïve investors, seeing only a lower P/E ratio, bid up the remaining shares resulting in price appreciation. Keep in mind, share buybacks only add value to shareholders if a company is below its intrinsic value, but this becomes a self-fulfilling prophecy if investors narrowly define “value” by P/E ratios, which are depressed by the practice. The buyback phenomenon explains why the stock market can look fairly valued by the popular P/E ratio (below), while appearing dramatically overvalued by many other more nuanced metrics (above). Valuation metrics that are not as easily manipulated by share buybacks (e.g. EV/EBITDA, P/S, P/B) are near or above levels achieved before market crashes in 1928, 2000, and 2007.
If share buybacks were actually good for long-term shareholder value, why would so many insiders be selling? According to TrimTabs, insiders sold $7.6 billion of shares in November 2015 representing the fourth highest monthly level on record. Consider the fact that buying back overvalued shares of a company using debt only benefits those who are out the door first, and today that means insiders and activists. This is not about shareholder value; quite simply this is a form of theft. Corporate executives and activists are using ultra-accommodative monetary policy and leveraged share-buybacks as a wealth transfer tool at the expense of long-term shareholders (aka, Pension systems and mutual funds representing the middle class). Investors will eventually wake up to the fact that you cannot rely on leverage and financial engineering indefinitely in the absence of intrinsic growth.
Share buybacks have an adverse effect on stock market volatility. Mean reversion is artificially incentivized when large swaths of price insensitive buyers are constantly seeking to buy on dips. The period to watch is the two to three weeks during and after earnings announcements, when the SEC mandated share buyback blackout period officially ends. In the past two years this period has encompassed three of the top ten “supernormal” volatility drawdowns in history. This includes the largest drawdown in the VIX in history, the 10 day and 42% decline that ended in October 2015. It will be interesting to see if buybacks can drive another relief rally into earnings season in late January 2016.
Share buybacks have had definitive effects on shaping the psychology of volatility short sellers into expecting mean reversion. Fundamentally, they also decrease volatility by smoothing out the EPS growth profile of corporations. The volatility of S&P 500 earnings per share is directly linked to the volatility of the stock market, so smoother EPS, manipulated or not, will reduce equity volatility (see chart). Empirically share buybacks have helped drive the highly mean reverting volatility environment. The next part of my letter will focus on the factors that influence and/or may cause an end to the buyback mania and mean reversion regime