The End of Buybacks

Everyone knows how hard it is to generate anything more than midsingle digit capital gains these days--which is why many investors have piled into dividend stocks to try to boost total returns. It’s also one of the reasons the market has seen an increase in share buybacks over the past few years. Companies, many flush with cash, are buying back outstanding stock, which then helps push up their stock price.

Companies spent $561 billion on stock repurchases in 2015: That's a 40% increase from the year before, and it was the most money spent on buybacks since 2007. According to FactSet, buybacks accounted for nearly 60% of shareholder distributions in 2015.

The buyback frenzy has been good news for investors; buybacks have added an annualized average of 1.64% to S&P 500 returns between 1983 and 2014, according to Morningstar. But it seems as though the good times are about to end.

In its Buyback Quarterly report, FactSet revealed that quarterly buybacks declined by 6.8% year-over-year in the second quarter of 2016, while the quarter also saw the smallest buyback total since the third quarter of 2013. Buyback participation also fell, with 350 companies participating in buybacks versus 380 a year earlier. While this is only one quarterly report, Philip Straehl, a senior research consultant at Morningstar Investment Management, expects the pace of buybacks to slow over the next several quarters, and that could impact shareholder returns.

The Rise of Buybacks Share buybacks are not a new phenomenon. Before 1982, stock buybacks were seen as a form of share price manipulation, but after a rule change that year, equity repurchases became fair game. Since then, buybacks have been the "dominant form of returning cash to shareholders," says Straehl, who recently co-authored a research paper about the influence of buybacks on stock returns. According to FactSet, in every quarter since Q1 2010, buybacks have accounting for between 50% and 61% of shareholder distributions, with dividends accounting for the rest.

While buybacks have nearly broken all-time highs, Straehl points out that buybacks tend to rise when earnings climb and fall when earnings decline. To put it another way, the more money a company makes, the more its profits are returned to shareholders through buybacks. That has been the trend again over the past five years, says Straehl.

However, a number of buyback critics have said that some companies are repurchasing more in stock than they've made in earnings, which is a troubling sign. FactSet's data backs this up: It found that 137 S&P 500 listed companies spent more on buybacks in the trailing 12 months ending in Q2 than generated earnings, up from 113 the year before.

As well, buyback growth has significantly outpaced earnings growth. FactSet found that trailing 12-month earnings for S&P 500 companies saw a 3.7% average year-over-year increase in earnings over the past five years, while buybacks experienced a 17% year-over-year growth rate over the same time period.

"An element of payout rates is very high," says Straehl. "In some cases, reported earnings were lower than what was distributed back to shareholders. That's caused people to ask themselves what's going on."

This affects investors in two ways: Some companies may not be making enough to sustain the buybacks, and repurchases could help keep the stock price higher than where it should be based on earnings.

Earnings Set to Fall It may not be long before buybacks decline in a more meaningful way. Why? Because we're entering a five to 10-year cycle of falling earnings, says Straehl. We've already seen four consecutive quarters of dwindling profits in part because of the cyclical downturn in commodity prices, which has significantly impacted energy company earnings, he says. The strong dollar has also influenced earnings--it's made goods purchased outside of America less valuable when converted into U.S. dollars.

Longer term, though, a number of things will impact profitability. Many of the tailwinds that have helped earnings growth have run their course, says Straehl. U.S. companies have been able to take advantage of cost reductions due to cheaper labor in other global markets. Companies have also benefited from M&A activity, but that's slowing; many sectors are now highly concentrated in a just a few companies.

"Those tailwinds we experienced over the last couple of decades and shifting," says Straehl. "If earnings are structurally lower, then by extension buybacks could also be structurally affected."

Good and Bad News for Investors How will fewer buybacks impact investors? In some ways it may be positive for equity owners. While buybacks tend to add to total return in the short-term, a number of experts argue that they aren't good for longer-term shareholder value. If a company is spending its money on share repurchases, then it's not using its cash to help grow the business. Instead, it's just trying to keep its stock price afloat.

"If you think about why the company is doing the buybacks, they may be trying to maintain their earnings per share and especially their compensation scheme," says Roger Aliaga-Diaz, a senior economist at Vanguard. "It's not positive longer term."

If earnings decline, will companies become more prudent with their cash and invest back into business growth? That's the hope, says Aliaga-Diaz, but that will only happen if labor costs rise and the economy continues to move forward, he says.

Lower earnings, though, could stop companies from purchasing stocks at elevated levels. Share repurchases only make sense if a company's stock is undervalued, says Eric Kirzner, the John H. Watson Chair in Value Investing at Toronto's Rotman School of Management.

"If people say we're doing it because the stock is undervalued, then that's a legitimate reason to buy," he says.

However, research shows that companies often do the opposite. In May of last year, Goldman Sachs put out a report showing that the buybacks as a percent of total cash have been increasing every year since 2012, while P/E ratios have been rising since then, too. Buybacks were at an all time high in 2007, when S&P 500's PE ratio was more than 20 times earnings.

"Exhibiting poor market timing, buybacks peaked in 2007 and troughed in 2009," the company wrote in its report. "Firms should focus on M&A rather than pursue buybacks at a time when P/E multiples are so high."

In the short term though, investors should start expecting even lower returns than usual, says Aliaga-Diaz. He doesn't think a buyback slowdown will sink a stock in a way a massive dividend cut might, but "on average, returns may be lower than they used to be," he says. Vanguard is predicting equity returns in the 6% to 8% range going forward, and while equities will still provide a higher return than fixed income, investors need to be aware of what they're in for.

"It's time to have realistic expectation of future returns," he says.

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.