Share Buybacks Are Like Invisible Hand for Stock Market, But for How Long?
There’s an invisible hand that has been supporting the stock market for a while: share buybacks. You might not hear much about them in the news, but stock buybacks have been a giant force over the past few years. However, one has to ask: What will happen if the buybacks disappear?
Companies that trade on the stock market have been sneaky lately. They’ve been buying back their own shares. Certainly, this increases shareholders’ equity, but it makes the companies look better than they actually are.
At the end of the day, share buybacks make a company’s earnings per share (EPS) appear better than they really are. A company with 10,000 shares and net income of $10,000 would report EPS of $1.00. If the company buys back 1,000 of its own shares, its EPS increases to $1.11. Nothing has changed other than the share count, but the profitability looks like it increased by 11%.
Here’s a little back story before going into more details.
It almost feels like companies have become addicted to stock buybacks. Some of them have been so addicted that they’ve borrowed money (because it was cheap) to buy back their own shares.
In 2021, S&P 500 companies bought back $881.7 billion worth of their own shares. This figure was up by almost 70% from the 2020 figure and up by 9.3% from the prior record set in 2018. In previous years, there were instances of 75% or more of the S&P 500 companies buying back their own shares.
To give you some perspective, the worth of the S&P 500 companies’ share buybacks in 2021 was equal to the gross domestic product (GDP) of countries like Turkey and The Netherlands.
How are stock buybacks expected to look in the coming quarters and years?
Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, said the following:
Q1 2022 buybacks are expected to set a new record, with a wider range of issues benefiting from the EPS lift. Beyond Q1 however, it is unclear, as inflation and the Russia-Ukraine conflict may reduce excess buybacks. At the minimum, companies are expected to cover exercised options, with stronger-cash-flow issues continuing to reduce shares. Given the strong base buying, expected earnings, even with a potential consumer slow-down and lower margins, buybacks could set another record in 2022.
(Source: “S&P 500 Buybacks Set Quarterly and Annual Record,” S&P Global, March 15, 2022.)
4 Headwinds for Share Buybacks & Ultimately the Stock Market
Coming back to my earlier point, you have to wonder if the invisible hand of share buybacks will continue to support the stock market. There are several headwinds ahead.
First, inflation is sticking around. So far, companies have been able to pass on their higher costs to their customers. But if inflation stays around longer, companies might be forced to absorb their higher costs. This could mean lower margins and ultimately lower profits and cash flow. If that happens, will companies be able to keep buying back their own shares at their current pace?
Second, higher interest rates could lead to an economic slowdown. Just recently, the U.S. Department of Commerce reported that the U.S. GDP declined at an annual pace of 1.4%. That was an unexpected decline—and the first one since early 2020. An economic slowdown hurts revenues and profits, and it’s another factor that has a negative impact on stock buybacks. (Source: “U.S. GDP Fell at a 1.4% Pace to Start the Year as Pandemic Recovery Takes a Hit,” CNBC, April 28, 2022.).
Third, over the past several years, companies have taken advantage of low interest rates. As mentioned earlier, some of them borrowed money to buy their own shares. With interest rates moving higher these days, will companies continue to do the same? It’s likely they’ll think twice before borrowing money and making immense share buybacks.
Fourth, don’t forget the global economy. Even organizations like the International Monetary Fund (IMF) are questioning the global economic growth in 2022 and 2023. This could warrant multinational companies going into protection mode; they could be looking to build up their cash reserves and not use their capital to buy back their own shares.
Stock Market Outlook for When Buybacks Go Away
Dear reader, I can’t stress this enough: the next few quarters will be very interesting.
Despite companies buying huge numbers of their own shares, the major stock market indices have been severely volatile. There’ve been significant losses since the beginning of 2022. If we take out stock buybacks, will there be many buyers left in the stock market?
If, in the coming quarters, companies that trade on the stock market move away from buying their own shares, it might not be a pretty sight. It’s possible we’ll see a rigorous stock market crash, with losses getting much bigger.