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Buybacks: an American institution

US share buybacks hit record levels last year, setting off a barrage of complaints from populist politicians, but returning cash to shareholders is what successful companies are supposed to do, says portfolio manager Hinesh Patel, from our sister company, Quilter Investors.

In 2018, buybacks – the practice of companies using part of their profits to buy back shares from the market – hit a record of $1trn in the US. Although the level of buybacks as a percentage of market value has been higher in the past, the fact that it reached a record dollar value in 2018 sparked no end of headlines. In doing so, it set the inevitable populist band wagon in train with numerous millionaires from the US Democrats suddenly jumping to the cause of the working man.

True to form, each adopted the time- honoured complaint that buybacks are some form of arcane ‘financial engineering’. This is because they increase earnings per share (EPS) by reducing the free float of company shares on the market (as, once they’ve been bought, the shares are cancelled).

The more rabid tub thumpers also complain that by spending their profits in this way, rather than on increased salaries and benefits for their employees, such companies exclude the average working man. Of course, such politicking rather misses the point as returning cash to shareholders is the raison d’être for any listed company.

Cultural differences

Ever since the US decriminalised buybacks in 1982, they’ve grown to become a key tenet of how US companies return capital to their investors. This is in sharp contrast to the position in the UK and, to a lesser extent, Europe where investors have always relied on dividends to deliver the major part of their returns over time.

As a result of this, US dividend yields have historically trailed those on this side of the pond and, quite unlike the position over here, US dividends are closely correlated to US Treasury yields. This suggests that US company managers pay close attention to the ‘risk-free’ rate when setting dividend levels.

The other consequence of this approach by US company managers is that the ‘buyback yield’ on US companies tends to be far higher than the dividend yield on the S&P 500 index.

As the chart shows, the gap between the buyback yield and the dividend yield on the S&P has widened since the start of 2017, with the former now almost twice that of the latter.

Not surprisingly, this sudden boost corresponds with the huge tax breaks handed out to corporate America by the Trump administration.

Clearly, while US dividend yields closely follow Treasury yields, the buyback yield is driven by company operating earnings and, with something like $1.5trn in tax relief coming their way at the start of 2018, US company profits have rarely looked more hearty. This explains why we’ve seen US buybacks surge in recent years.

Riding the cycle

As the level of US buybacks essentially tracks corporate profitability, it’s obviously very cyclical. A good example of the process is provided by one of the most voracious US buyers of its own shares, namely Apple.

Last year it announced plans to spend $100bn in buying back its own stock from the market and has already announced plans to spend $75bn doing the same this year.

Naturally, Apple was one of the single biggest beneficiaries of the Trump tax cuts that were passed at the end of 2017. These slashed the corporate tax rate to 21% (from 35%) and cut the tax on overseas profits brought back to the US to between 8% and 15.5% (again from 35%) as well as exempting their foreign income from US tax.

In Apple’s case, its effective tax rate fell from over 24% to about 18% in 2018. It also saved billions in taxes on some $250bn of cash that it repatriated from overseas following the Republican’s tax bill.

Even so, its earnings before interest, tax, depreciation and amortisation (EBITDA) actually plateaued at the start of 2016, despite the massive tax relief it subsequently enjoyed.

However, its practice of hoovering up its own shares, either to cancel them outright or to hold them as part of its massive employee share scheme, has seen it reduce the number of company shares in circulation by around 28% since the peak back in mid-2013.

Consequently, even though its earnings have more or less stagnated in recent years, its earnings per share (EPS) have continued to rise.

Of course, such arithmetic is what provides ammunition for those who still label buybacks as ‘financial engineering’.

Historically, those US companies that spend the most on buyback and which consequently have the highest buyback yields, have outperformed the S&P over time.

Our own analysis shows that, on an annualised basis , the top 100 highest US buyback stocks have outperformed the S&P by an average of 2.16% a year.

But don’t make the mistake of putting the cart before the horse: they haven’t outperformed because of their buyback activity. They’ve outperformed because they’re the most highly profitable of all US companies. Their buybacks are a consequence of this, not the other way round.

US buybacks in 2018 and beyond

Prior to the 2017 tax cut, the tech giant Cisco, had more than $70bn in cash parked overseas. After the change in tax rates it promised to repatriate much of this and to put an additional $25bn toward buybacks.

Similarly, the big six bank Wells Fargo announced $22bn in buybacks, Pepsi announced $15bn, Amgen and AbbVie both committed to $10bn and Google’s parent, Alphabet promised $8.6bn.

Elsewhere, Apple announced $100bn of buybacks in 2018 and another $75bn for 2019. The latter announcement helped push its valuation back into 13 digits ($1trn).

1 Source: Quilter Investors/Bloomberg based on a seven-year moving average.

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