The 2019 equity rally has been called the rally everyone loved to hate. The reason being that after the correction of late 2018 and all of the signs pointing to recession, the S&P 500 seemingly did the impossible and rallied to have one of it’s best years. It just goes to show why you should stay invested and why market commentators (including this one) always end up wrong at least some of the time.

So what really produced this rally when everyone was expecting the market and the economy to slump in late 2018? The culprit, which is being blamed for the continued “hate rally” as I like to calm it, into 2020, may be share buybacks.

Why the Fuss About Buybacks?

Buybacks have gotten a bad rap by some market observers. They claim that too much corporate cash is being used to buy overpriced shares and should be going towards things like R&D to make companies more competitive in the future. Before I get into why this is not necessarily true, it may be worth going over why buybacks are so prevalent now and where they came from.

Buybacks started to trend in the mid 1980’s after the SEC adopted rule 10b-18 which gave executives a safe harbor against stock price manipulation charges. In 1997 they surpassed dividends for the first time in terms of their volume. There is a totally reasonable explanation for why buybacks make sense for a corporation and why they exceed dividends from time to time.

The first being that buybacks, just like dividends, are a sign of a mature company. Dividends are distributed to shareholders when management believes there is more capital than there are growth opportunities to spend on. This is usually after a long period of high growth where few dividends are paid out. Investors love dividends. After falling out of love with them during the dot com bubble in the 1990’s they rediscovered them in the 2000’s. Dividends are responsible for about 43% of total returns for the market since 1930. Since the Bush tax cuts in the early 2000’s, they also have a tax advantage in the US if they are qualified dividends, which must meet some criteria like listing with the IRS. This means that they are taxed at long term capital gains rates which means 0% to 20% and with much higher thresholds that’s for wages. That’s the way that billionaires are able to pay a lower tax rate than their secretary, but that topic is for another post.

Dividends also have some cultural aspects to them. For some reason, in the US investors hate when companies cut dividends. They like to see a long, uninterrupted gradual increase in dividends. Any dividend cut is taken as a signal that management can’t do its job and would seriously endanger management’s position at US firms. So companies are loath to cut dividends in the US for fear of the market repercussions. In other countries this is not the case. Dividends are seen as the bounty of good times and are paired back when things get tight.

This is also what makes management want to devote only a minority portion of earnings to dividends and then raise it slowly. They take the most conservative approach to this type of shareholder return of capital. What if however, there was a way to pay shareholders that didn’t punish management and wasn’t taxed? Sounds like the ideal tool for management to reward shareholders right? Well that’s exactly what buybacks are.

The Shadow Dividend

While market participants hate dividend cuts, when buybacks are cut, they are not as punishing. This is one reason management likes them as well: they can add them or withdraw them with the ups and downs of earnings without hurting the dividend. There is evidence that this is exactly what has been happening in the past few years.

Source: Market Watch

Notice how since the early 2000’s, dividends as a percentage of free cash flow has been relatively smooth while buybacks have varied wildly.

This distribution also isn’t taxed like a dividend. In fact, the theory on shareholder returns says that if there were no taxes at all, shareholders should be indifferent between dividends and buybacks. Especially since that 43% return due to dividends is assuming you reinvested your dividends when you received them.

In this sense, I look at buybacks as a sort of shadow dividend, that management can add and take away more at will and more contingent upon earnings. In this sense the argument that there could be more employee benefits or more R&D doesn’t make more sense. Attacking buybacks as taking away from employees and R&D doesn’t make any sense if you aren’t attacking dividends as well. I don’t see as many commentators making the argument that dividends are hurting firm competition and taking away from employees.

Fuel for the Hate Rally

There is some evidence that the rally in 2019 was due to corporate buybacks as well. Large market participants such as mutual funds, pension funds insurance companies and foreign investors have been pulling money out of stocks, so why the rally?

The answer may be that corporate buybacks are shelling out enough to offset all of those phenomena. It’s even more striking when you look at the equity market inflows on a cumulative basis.

Source: BofA

Buybacks decrease the number of shares in the market and will allow companies to increase the earnings per share figures with the same amount of profit, all other things being equal. So not only will it provide an outlet for selling shares, it will provide more earnings per investor.

Despite this, another criticism of buybacks is that some companies are doing it with debt. I.e they are issuing low cost debt to use the funds to buy back shares. Clearly the ability to do this will depend on the firm, how indebted they are and the rates they are paying. If I am a shareholder however, why would I not want management to use this low interest rate period to pay me more money? As long as the debt is used responsibly, what is the hard. Apple has even issued some negative debt, if companies are being paid to take investors money, why not use this advantage to reward shareholders?

The large banks may well be already doing this. When I reviewed large bank earnings recently, I noted that many bank such as Bank of America and JP Morgan were returning more cash to investors than they made in earnings. This could potentially be field by debt or returning some idle capital to shareholders depending on how you look at it. Either way it has contributed to a great rally in US bank shares that is long overdue after the beating bank investors took during the crisis.

Will the Rally Continue?

With profits flat or declining and corporate debt increasing, the question is for how long can this buyback rally continue? Low interest rates and Fed intervention are definitely helping the case by keeping debt cheap and making equity more attractive compared to cash or bonds. The big question is whether earnings will hold up over Q4 2019 and Q1 2020 to be able to sustain the rally. It will be an interesting few months.

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