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Corporate Buybacks Aren’t What They Used To Be

“Financial Engineering” as it applies to a corporate structure usually is defined as the aggressive use of various techniques to enhance shareholder value by affecting the balance sheet. Probably none has received more attention over the last several years as stock buybacks. It seems that not a day goes by that CNBC and the financial media are reporting that companies have initiated or increased share buyback authorizations, and there has been a great deal of attention given over the last many months to whether share repurchases represent a judicious use of a corporation’s capital. In this report we will attempt to shed some light on this topic and also examine what message the market may be saying about large companies that are doing buybacks. This is possibly one of the most important questions facing market participants today since the U.S. has been in a zero or near zero interest rate environment for 87 months (an unprecedented amount of time.) During that time corporations have raised record amounts of long-term debt at historically attractive levels, while at the same time remaining voracious buyers of their own shares. The major buyback companies as a whole have outperformed over the last 7 years, since the bottom on 3/9/09. However, this recently has not been the case as we will illustrate. Now in this era where it seems there is an index for any financial asset class that can be measured, there are indexes of companies that are buying back their own shares. The performance metrics of the two most popular are reasonably similar so we will focus on just one, the S&P 500 Buyback Total Return Index (SPBUYUT). This index is calculated by S&P back to 1994 (numbers sourced from Bloomberg), though it appears a more recent creation since trading volumes and ranges don’t appear until 2013. This index is equal dollar weighted and rebalanced quarterly. It is a subset of the S&P 500 consisting of the 100 companies that for the 4 previous quarters have repurchased the largest percentage of their market capitalizations. We will compare this to the S&P 500 Total Return Index (SPXT). This index is capitalization weighted and like SPBUYUT reinvests dividends. It is thus a reasonable “apples to apples’ comparison. While we would argue that returns on financial assets have been inflated by an experimental and dangerous environment the Fed has created through QE and ZIRP, the numbers tell us that since the market low on 3/9/09, SPXT has returned 252% while SPBUYUT has returned 374%. A shorter and more recent time frame, however, tells a somewhat different story. Since the 3/9/09 market low there are 29 rolling 4 quarter periods we examined. Of the 29 periods, there have been five where SPBUYUT underperformed. There were 2 in 2012 and the most recent 3 (through this writing on 3/29/16). The largest of the 5 is the last 4 quarter roll and the underperformance number is 7.02%. So we believe that the market is starting to punish companies that are the most voracious buyers of their own stock. There are several arguments made by buyback opponents that go as follows: Buybacks steal from the future by expending resources that should be used to fund/ensure future growth in exchange for the short-term gratification of a higher stock price that is the result of the buyback. Worse yet, if financed with debt, the debt has to be serviced and paid back eventually. Buybacks do not return money to all shareholders (as dividends do) but rather only to selling shareholders; (that are now no longer shareholders) Corporate managements have an inherent conflict of interest when, as is typically the case, their compensation is determined by EPS metrics that are influenced by the buybacks they authorize. These arguments make sense to many, including us. It is likely true, however, that when the markets are near the high end of their all-time ranges, most investors either don’t care or overlook these facts. When the extended bear market that we see coming arrives in earnest, we believe the finger pointing and recriminations will arrive with it. In summary, our regular readers know that we believe the U.S. is in a long term deflationary cycle that is the result of excessive debt (see Cycle of Deflation ). The debt situation has been exacerbated for the last 87 months by the “experiment” of QE and ZIRP by the Fed. Other Central Banks have followed with their own QE and ZIRP/NIRP. During this time frame corporations have been large buyers of their own stock with much of it financed by debt. This most certainly has been a prop under the market. But as stated above, corporations are doing so to the detriment of long-term investment in the business. While in the past, indexes of companies doing buybacks have outperformed their market benchmarks, that has started to change recently. Buybacks done at elevated levels of valuation will prove to be ill conceived and ill timed (think Devon Energy and Amerada Hess which recently needed to sell equity at levels far below stock repurchase levels of the past several years). Companies doing excessive buybacks will negatively affect future growth by underinvesting in capital assets; all the worse if financed with debt. Because of the aforementioned facts and circumstances, yesterday’s stock buyback winners could prove to be tomorrow’s losers. We believe that will be the case.

Finding Silver Linings In Cloudy U.S. Equity Markets

By Frank Caruso, Kurt Feuerman, Dan Roarty, James T. Tierney, Jr. Investors in US equities are facing tricky market conditions. To help stay focused in today’s environment, we’ve outlined five “plays,” or investing principles, for identifying the long-term drivers of a company’s business, which should foster sustainable growth. After the recent correction, equity managers can access stocks of stronger companies at attractive valuations to better position a portfolio for long-term investment performance. By using research to focus on the long-term drivers of a company’s business – and with a disciplined approach to portfolio construction – we believe investors can find silver linings in cloudy US equity markets by following a playbook of five clear investing principles (Display). Click to enlarge Play 1: Be on the right side of change : Changes in technology or regulation, or structural shifts in specific markets are excellent sources of growth potential – even in an earnings-constrained world, in our view. Play 2: Look for sources of secular growth : Identify growth trends that aren’t held hostage to a country’s macroeconomic fortunes. Play 3: Find businesses that control their destinies : Companies with better products, superior operating execution and more responsible financial behavior are likely to exercise a greater degree of control over their own fate. Play 4: Don’t confuse price momentum with business momentum : There are countless reasons to explain why share prices rise or fall sharply. It’s not always a sign of the strength or weakness of the underlying business. Play 5: The best defense is a solid offense : Popular safe havens in the markets aren’t always as secure as they might seem. Be creative when searching for stocks that can withstand volatility. In the coming weeks, we’ll publish additional blogs providing more detail on each of the plays. All five plays share a common denominator: they’re aimed at finding companies with sustainable growth prospects in a volatile, low-growth world. While relatively few companies fit this profile, our research suggests that investors who find them can enjoy outsize returns (Display). Click to enlarge When volatility strikes, it’s hard to stick to an investing playbook. Just like a football team that’s losing an important game might abandon a plan and improvise in the hopes of staging a recovery, investors under duress can be tempted to shift a portfolio or allocation in response to market surprises, while losing sight of their strategic goals. It usually doesn’t work. Staying disciplined in the face of adversity is more likely to yield better results, in our view. Of course, there are many different ways to implement our investing plays in the US equity market. A growth-centric manager can use them to find high-return, cash-generative businesses with clear paths to implement their strategy. An unconstrained manager can use them to create a portfolio of companies that balances high-quality cyclical and noncyclical holdings. The playbook can also be used to create a concentrated equity portfolio of a very small group of stocks with unique, differentiated business advantages. For a thematic approach, a portfolio manager can apply these ideas to navigate disruptive trends that are creating big opportunities in new markets. With these concepts in mind, we believe investors can find the right approach to capture excess returns over long time horizons, no matter how unruly markets are. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Frank Caruso – Chief Investment Officer – US Growth Equities Kurt Feuerman – Chief Investment Officer – Select US Equity Portfolios Daniel C. Roarty – Chief Investment Officer – Global Growth and Thematic James T. Tierney – Chief Investment Officer – Concentrated US Growth

Pulling More Levers Across Emerging Markets

By Morgan Harting After five difficult years, signs of life are emanating from emerging markets. Investors seeking to rediscover the developing world might consider the benefits of pulling more levers across asset classes. Since the global market correction in January, investors have been taking a fresh look at emerging markets. The MSCI Emerging Markets Index has risen by 21% since January 21 in US dollar terms, through March 21, outperforming global developed stocks. Meanwhile, the J.P. Morgan Emerging Market Bond Index has advanced by 7%. Fund flows to emerging market equities and debt have been positive for several weeks following three years of net outflows for equities and one year of net outflows for bonds. Improving Risk-Adjusted Returns Yet for many investors, emerging equities still seem scary. They’re much more volatile than their developed market peers, so there can be a cost to accessing their return potential. That’s why a multi-asset approach can be very effective. By reducing risk significantly, it can help investors maintain exposure to the underlying long-term growth story that underpins the attraction of investing in the developing world. Our research compared the risk-adjusted returns of four approaches in emerging markets: 1) a cap-weighted equity index; 2) a skillful tilt toward better-performing equity countries and sectors; 3) a multi-asset approach that bolts together equity and debt indices; and 4) a portfolio that skillfully tilts toward the top-performing-quartile country and sector within each asset class. Bolting together emerging market stock and bond indices would have outperformed an allocation to passive equities – and generated stronger risk-adjusted returns than even a skillful stock picker could have achieved (Display). But an equally skillful multi-asset manager that tilted toward better-performing countries and sectors in stocks and bonds would have done even better, our research suggests. Click to enlarge Stocks and Bonds Move in Tandem Why does an integrated multi-asset approach work so well in emerging markets? Performance patterns can help answer this question. Stock and bond markets in developing countries are highly correlated, meaning they tend to move in the same direction. But emerging stocks are also much more volatile. As a result, when investors are optimistic about a country’s growth prospects or diminishing risk, capital inflows to local markets often fuel gains for both stocks and bonds. Conversely, concerns about financial stability or recession usually hurt both asset classes. Higher bond yields trigger an increase in the discount rate applied to company earnings, which pushes down stock prices. Take the recent example of Brazil, which slipped into recession last year. Investors sold both Brazilian stocks and bonds, which declined 41.4% and 13.4%, respectively. More recently, as investors became optimistic about a potential change in government, Brazilian assets have rallied, with stocks and bonds up by 29% and 12.7%, respectively, for the year through March 21. So combining emerging stocks and bonds in a single portfolio preserves the underlying risk exposure, but at a significantly lower level of volatility, in our view. And the reduction in volatility will often outstrip any reduction in returns, underpinning a dramatic improvement in risk-adjusted returns, as shown above. Dispersion Within an Asset Class Isn’t Enough Brazil’s recent volatility highlights the challenge. The emerging equity index spans 24 countries and nearly as many industries, affording an active manager ample opportunity to take active positions and outperform an equity index . Yet, when emerging stocks collectively face downward pressure, there aren’t enough places for an equity-only manager to hide. Last year provided a good example when the emerging equity index fell 15%. The quilt display below shows that India was the top-quartile segment in equities, falling 6%, while the worst quartile was Mexican telecom, down 31%. So even if a skilled manager put all of her eggs in the top equity quartile basket, the portfolio would have suffered significant losses. Click to enlarge Widening the opportunity set to include bonds could have dampened the downside risk. Even the worst-performing quartile of dollar-denominated government bonds – Tanzania – outperformed the best equity quartile. This dynamic is not unusual. The worst quartile of dollar sovereign bonds outperformed the best quartile of equities in 2011, and in 2008 as well. Combining emerging-market equities and bonds in a multi-asset portfolio gives a manager more options to find the right balance of returns. We believe this type of structure can provide a strategic advantage over bolting together independent equity and bond portfolios. It’s too early to say whether the tide has definitively turned in emerging markets. But recent enthusiasm might be a signal for investors who are underexposed to emerging markets to think about reentry. By pulling more levers from the broadest universe of securities in a portfolio of carefully chosen stocks and bonds, we believe investors can regain the confidence to return to emerging markets and capture smoother return patterns through the volatile conditions ahead. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.