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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.

Driving In Neutral

By Neuberger Berman Asset Allocation Committee So far, 2016 has been characterized by stomach churning swerves in market direction with little actual change in levels. When the Asset Allocation Committee recently met to update our views for the coming 12 months, most participants felt that a variety of factors was in effect, setting a speed limit on big directional market moves. The most obvious of those factors is the Federal Reserve (Fed), which now looks set to deliver only two rate hikes this year, when as recently as December the market expected as many as four. FOMC policy makers seem willing to let the dollar act as a substitute for further tightening while they await stronger economic data and evidence of core inflation growth that’s closer to their 2 percent target. The coupling of oil and equity prices is acting as another governor on higher valuations, making it hard for risk assets to sustain advances. Elsewhere, other major central banks are seemingly stuck in neutral against an uninspiring economic backdrop. European Central Bank (ECB) chief Mario Draghi received a chilly response in suggesting no further rate cuts would be coming after unveiling a new easing package in early March. In Japan, there is a genuine crisis of confidence in quantitative easing efforts now that negative rates have only produced similarly negative feedback. Meanwhile, China is caught between the need for additional stimulus and adherence to its reform agenda, increasing the risk of a significant devaluation of the yuan. In light of these constraints, the Committee believes that the recent rebound in equity prices, while welcome, needs evidence of rising earnings and improving economic fundamentals to continue. At the same time, we observe that the market has been experiencing rapid rotations among sectors and across asset classes, creating significant divergences that may yield opportunities to add value within and across individual categories. As such, with little visibility over the coming three to six months, we favor an approach of continued selectivity in pursuing risk asset opportunities through trades within asset classes rather than large directional bets, and to wait for pullbacks to consider adding to positions. Outside of non-U.S. developed market equities, the Committee maintained its neutral stance on U.S. and emerging market equity and adjusted its outlook for master limited partnerships (MLPs) to a neutral position. We are maintaining an underweight view of most developed market government securities because of our view that low yields do not compensate for the risk of higher rates, and remained cautious on emerging market debt with a bias toward hard currency sovereigns. Global Equities Among Few “Slightly Overweight” Calls History has shown that U.S. equities (as measured by the S&P 500) have often benefited when the Fed is in the midst of a tightening cycle. The main reason is that corporate earnings tend to rise as the economy strengthens, offsetting the impact of higher borrowing costs. But if you look at what’s happening during this cycle, average price-to-earnings ratios have declined by a full percentage point in the face of tepid to flat earnings growth. This fact was not lost on the Committee, which voted to maintain its neutral stance on U.S. equities even as most members expressed their belief that the country will avoid another recession for the time being. On the other hand, the Committee believes that global equities–and particularly those in developed markets outside the U.S.–may provide more opportunities over the coming 12 months. Despite the latest ECB posturing on rates, evidence is growing that past stimulus is providing a tailwind for growth. Business confidence continues to be decent, credit demand is rising, and corporate profits have yet to recover to post-crisis levels as they have done in the U.S. Among fixed-income assets, the Committee continues to favor high yield given current prevailing yields and the outlook for credit quality. But given the likelihood for ongoing fallout from weakness in the energy sector, we continue to prefer short-duration issues and higher-rated credits, at least for the near term. We feel clients looking for additional fixed-income exposure may want to consider shifting their exposures in assets such as core European bonds, burdened by negative yields, to high yield and select portions of the emerging market debt universe. Move to “Neutral” on MLPs The move to neutral from slightly overweight on MLPs was a difficult one given our prevailing belief that investors had unfairly punished the asset class amid ongoing weakness in energy markets. Many market participants have been caught off-guard by both the depth and persistence of that weakness, and the Committee feels that further declines in commodity prices in recent months have increased the potential for additional restructuring in the energy sector and added to the downside risks faced by midstream operators in particular. Broader Array of Risks The Committee agreed that a step-devaluation of the Chinese yuan remains the centerpiece risk in the investment outlook over the coming 12 months, but other downside scenarios featured more prominently. Chief among these was the risk that the Fed proceeds with tightening too quickly and undermines confidence in market liquidity, and that emerging markets such as Brazil create a contagion effect for developed market risk assets. Political risks are also rising, including the possibility of “Brexit” as the UK holds a June referendum on membership in the EU, and uncertainty around the U.S. presidential election. Driving in neutral can still get you down the road, but not without shifting into “drive” from time to time. In the months ahead, we believe it will be important to be vigilant for opportunities to add during market pullbacks and pursue trades within broad asset categories when the associated risks are acceptable. We believe the value of active management may be more evident during periods when asset allocators have little cause for conviction, and we anticipate that a firm hand on the wheel over the coming months will be key in helping navigate this uneven terrain. This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. 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