Now here’s a big tip for investors – big US companies no longer think their shares are the bees knees when it comes to spending shareholder funds.
There’s been a noticeable slackening in the rate of announcements spending on buybacks in the US market (which is where buy backs are most common).
According to the Financial Times companies spent just over $US22 billion buying back shares this month – nearly a third of the $US61.7 billion spent in June 2013.
And why is this important? Because it’s a valuable indicator of how insiders – company boards and managements – view market conditions and their company’s value.
And it seems boards and managements no longer think the market is well-valued and their company shares are not worth investing company money in (and perhaps damaging their remuneration).
It’s an indicator that perhaps markets are becoming overvalued, or as the Bank of International Settlements commented at the weekend – markets are "euphoric" and "extraordinarily buoyant”.
That was used to describe all capital markets – but for more and more US companies, its an apt description of sharemarkets which have recovered from the fears about tech valuations in March and April, and have gone on to a succession of new all time highs.
And you don’t have to look any further than 21st Century Fox – the key company of Rupert Murdoch and his family.
It has had a share buyback happening since July 2011 when the News of the World scandal hit the company’s former parent, News Corp.
It bought shares consistently up to early May, spending $US9.8 billion on buying 436.6 million non-voting shares.
But since then, not a dollar has been spent and Fox shares have remained remarkably solid.
Fox’s decision to turn off the taps has been echoed across the broader market.
In fact buybacks in the US market peaked in February of last year and have been on a low steady slide since then.
And the number of companies announcing buybacks this month is currently 38, the lowest figure since June 2011, according to the FT’s figures.
Buybacks are either the last resort for managers who cannot think of anything productive to do with their cash – the size of their bonuses and value of their options often depend on rising profits and earnings per share and the fastest way to give that a boost is a buyback which reduces the number of shares on issue – thereby boosting EPS.
Buybacks are also used by companies to support the shares in times of rising tension – such as what News Corp did in July 2011 when the News of the World crisis broke.
Companies and their boards and managers often choose buybacks over capital investment because of the favourable impact on remuneration – investment in new facilities can reduce earnings growth in the short term, cutting the pay of managers.
The most interesting signal from the slowdown in spending on buybacks is sending to investors is that more and more managers no longer think their company’s shares are undervalued or ‘cheap‘.
The interesting thing is that many big companies, especially in pharmaceuticals and other tech areas, are spending money on mergers and acquisitions.
It is well known that takeovers/mergers have a very poor track record for delivering the sort of value that buybacks do – to shareholders and to managers.
Cash bids are booming – according to the FT more than $US74 billion in such bids were announced in the last six weeks – the highest six week total since June – July of 2007 – just as the GFC was starting to erupt (it actually started over August 8/9 2007).
That should be another portent for the careful investor to keep in mind.
And finally, this is something to keep in mind as we head to the reporting season in Australia and the two companies that will be at the centre of speculation about buybacks – BHP Billiton and Rio Tinto.
If they instead make capital expenditures, governing politicians would be delighted, as this column has commented before.
But companies’ use of cash can also be a valuable “tell” on whether they truly think their stock is too cheap. In other words, managers who believe that their stock is undervalued can signal as much, and boost their shareholders’ returns, by boosting earnings per share.
Companies with strong buybacks have been persistently rewarded during the post-crisis rally. In the last five years, the PowerShares Buyback Achievers fund, loaded with companies that make big buybacks, has returned 22.7 per cent per year, compared with 18.8 per cent for the S&P (and 19.6 per cent for the biggest high-dividend yield fund).
But buybacks cease to make sense if a stock is overvalued. They still raise earnings per share, but the transaction wastes cash on an overpriced asset.
So judged in isolation, falling buybacks show flagging confidence among corporate executives that their stock is cheap.
It should not be judged in isolation, of course. New offerings, which make most sense if stock is overvalued, are rising, both through secondary offerings and through initial public offerings, which have recently seen well-known names such as data group Markit and GoPro, the camera maker, come to market. IPOs are also strong in Europe.
As for selling of shares by insiders, the classic sign that the people in the know think that their stock is too expensive, TrimTabs shows that it has risen sharply in recent weeks.
Against this, there is one sign of robust confidence, which is the return of mergers funded by cash (which generally means debt). They have exploded, and $74.4bn was spent on cash acquisitions in the last six weeks. This was the highest six-week total since June and July of 2007, when there was a flurry of dealmaking before the credit crunch set in.
Cash mergers are another way to shrink the supply of stock, and also tend to drive up the value of shares (even if they do not necessarily create any economic value).
But a sudden rash of deals like this looks unhealthy, and suggests that executives are building their domain while they can ahead of a market top, as appeared to happen in the summer of 2007.
In any case, announced corporate buying (including cash mergers and buybacks) has outnumbered new offerings by only 1.6 to 1 since the beginning of May. For the year as a whole, the figure is 2.6 to 1.
Another way to look at this, favoured by Ned Davis Research, is to compare growth in earnings per share with total cash earnings (without dividing by the number of shares). So far this year, EPS growth is lagging behind total profits growth by 0.3 percentage points. This reverses a trend in place since 2005, when dollar-based earnings have tended to lag EPS.
Ned Davis Research finds that the market tends to reward dollar earnings growth more than EPS growth; investors are more impressed by real economic expansion than by financial engineering. However, periods when EPS grows faster than dollar-based earnings (which have only happened about 20 per cent of the time since 1982) tend to occur just before periods of outright falls in earnings. While this is not imminent, Ned Davis Research suggests that it is “worth monitoring”.
As for investors’ attitudes to this, the Buyback Achievers fund is trailing the market this year, gaining 8.5 per cent, against the S&P’s 14.9 per cent.
It is difficult to spot a correction coming. The balance of evidence still tends to point towards a continuing rally before the correction comes. But the pick-up in deals, and the shift in the use of corporate cash, do suggest that the market is getting ready for one.
