Whatever else you may think about stock buybacks, it’s quite likely that, but for them, the U.S. stock market today would be markedly lower.
That is the implication of a study published last year in the Financial Analysts Journal, “Net Buybacks and the Seven Dwarfs,” by three researchers from the Abu Dhabi Investment Authority. They found that net buybacks—the number of shares that companies repurchased across the entire stock market, less the number of new shares issued—explain the bulk of the intermediate- and longer-term differences in stock-market returns around the world.
This comes as a surprise, because the conventional wisdom is that economic growth is by far the most important factor in the outperformance of certain countries’ stock markets in recent decades. The researchers found little support for this belief.
Take China, whose economy over the past decade has grown at one of the fastest rates of any major country. China’s real GDP, in U.S. dollars, grew at an 8.0% annualized rate over the 10 years through year-end 2018, versus a 2.1% annualized rate for U.S. GDP. And yet U.S. equities’ annualized return over this decade was more than double that of China’s.
This was not a fluke. In an analysis of 43 countries’ stock markets between 1997 and 2017, the researchers found those that performed best were, on average, those with lower economic growth rates. Similarly, the researchers found that the variances in countries’ equity returns had little to do with any of the other usual suspects to which analysts often turn when trying to account for countries’ varying equity returns, such as inflation, currency fluctuations and profit margins.
To be sure, these other factors (the “Seven Dwarfs” referred to in the title of the study) sometimes will have an outsize shorter-term impact. But their effects often cancel each other out over time. The result is that, over the long term, net buybacks dominate all other factors. For example, the researchers found that net buybacks explain 80% of the difference in countries’ returns between 1997 and 2017.
They have this outsize impact because they increase the share of corporate profits accruing to existing shareholders, just as net issuance leads to a dilution of their share. Once again China provides a perfect illustration. The researchers calculated that the issuance of new shares in the Chinese market—largely as state-owned enterprises went private—had a “massive dilution effect” of nearly 24% a year between 1997 and 2017. Little wonder, therefore, that the country’s equities struggled over this period, despite its economy’s incredibly fast growth.
The picture painted by the U.S. data is far different. Over the same two-decade period, the comparable dilution rate for the U.S. stock market averaged just 1.8% a year, according to the researchers. And this dilution was concentrated in the first years of the period; since 2006, net buybacks in the U.S. have actually been positive (see chart). Buybacks last year set a record, according to S&P Dow Jones Indices (.DJI), with S&P 500 (.SPX) companies spending $806.4 billion on repurchases, far outpacing the previous record of $589.1 billion in 2007.
David Santschi, director of liquidity research at TrimTabs, goes so far as to argue that buybacks are one of the two biggest reasons why the stock market has been so strong over the past decade. The other, he says in an interview, has been “massive money creation by global central banks.”
Still, be aware that net buybacks aren’t particularly helpful as a short-term market-timing tool. One reason, according to William Bernstein, co-principal at Efficient Frontier Advisors, is that corporations are notorious for their awful market timing—buying shares in good times when prices are high, and not in bad times when prices are low. Ironically, though, he added, net buybacks’ positive impact on the market’s long-term returns is the same regardless of whether corporations’ individual repurchase decisions were wise or foolish.
The clear implication, Mr. Santschi says, is that—other things being equal—the U.S. stock market’s expected future return will be lower if buybacks are restricted. That isn’t necessarily a bad thing, he adds. And Mr. Bernstein agrees: “What’s good for investors is often not good for society as a whole.”
Regardless, Mr. Santschi recommends regulatory changes that would make it easier for investors to track net-buyback activity. “Companies should be required to disclose their actual buybacks on at least a monthly basis,” he says. Furthermore, “they should not be allowed to announce new buyback authorizations until they have completed all of their existing buyback authorizations.” He says that is because the buyback announcements that some companies currently announce “can be confusing to investors.”
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