What Does Shrinking Equity Supply Mean?
My friend Brian Reynolds, chief market strategist at MS Howells & Co., has long said that Buybacks have been a driver of stock prices, with the shrinking float the key reason why. Econ 101 says that reduced supply with the same demand equals increased prices.
There are some caveats: Companies always could add shares back by new issuances, so equity is not quite like a commodity with a finite supply (Oil and Gold come to mind).
We were discussing this in the office yesterday, and the example I used was Paul Kasriel's recent chart. It showed up in Barron's today, with an interesting spin, and that's kismet enough for me:
"THAT DANDY LITTLE CHART WITH THE HOPEFULLY catchy head of "Off a Cliff" on this page comes to you courtesy of Paul Kasriel, Northern Trust's crack economy watcher. What it shows is the dramatic shrinkage in the supply of equities; all told, a record $548 billion worth was "retired" in '06. As Paul explains, rather than using their vast profits to fund capital spending, corporations have been buying in their own stock, hand over fist. Further soaking up the supply of stocks has been the explosion in private equity. It's hardly a surprise, then, he says, that stock prices moved up as smartly as they did.
Paul also points out that the massive corporate buybacks and scarfing up of shares by the acquisition-hungry private- equity types have had another effect: Together with mortgage-equity withdrawal, they've helped fund the $503 billion deficit that households ran last year. Said households, either directly or indirectly via mutual funds or pension funds, he reckons, were net sellers of stocks in 2006.
Which suggests, according to Paul, that unless corporate buybacks or personal income steps up sharply, with mortgage-equity withdrawal (MEW) likely to slow further this year, Jane and John Q. will have to clamp down on their spending. The stage seems set, in other words, for the end of the great consumer buying binge."
A few things worth pointing out:
• If MEW slows, that would potentially engender either more stock selling to fund a certain lifestyle -- or decreased consumer spending.
• There is, according to Barron's, a "sizable build-up in pending new issues. By one savvy estimate, the number of IPOs in '07 could shoot up a formidable 50%."
• Share repurchases are heavily dependent on corporate profits. If the earnings deceleration trend continues, so too might buybacks.
One last thought: Late 1990s saw a similarly large net share decrease. As prices rallied to new highs, we saw a return to trend. Once the market cracked, buybacks went away.
In other words, the psychology of the financially engineered buyback is a double-edged sword. If either the market seriously corrects or the economy slows (or both), we should expect buybacks to drop too.
> Sources: Corporate Equities: If the Supply goes down, the Price is Likely To Go Up (PDF)
Dipsomania?
ALAN ABELSON
Barron's, March 12, 2007
http://online.barrons.com/article/SB117337756928631125.html
Paul Kasriel
Northern Trust Global Economic Research, March 8, 2007
http://web-xp2a-pws.ntrs.com/content//media/attachment/
data/econ_research/0703/document/dd030807.pdf
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» Net equity issuance from Wcw
Net issuance of corporate equities as percentage of outstandingfour-quarter-trailing issuance over trailing average
I do like Paul Kasriel for reminding me of data at which to look, but he has a habit of not normalizing historical series. Tipped by Ba [Read More]
Tracked on Mar 10, 2007 2:04:07 PM
Comments
"Kismet" ? Hadn't heard that word used in a long time.
Googled the word, interesting what turned up.
To me, it pretty much looks like stock buybacks have replaced dividends and/or capital funding.
Long Term that has to be a disaster for workers(maybe even business in general) if paper gains become the only future economic growth for the US.
and then you have to wonder what happens when that well runs dry too?
Have a good weekend
Posted by: MarkTX | Mar 10, 2007 10:11:28 AM
Well personal income is up sharply!
Posted by: Fullcarry | Mar 10, 2007 11:02:58 AM
KISMET appears to be related to the Hebrew work "KESEM" which is usually translated as MAGIC.
"Outside the Housing and Auto Industries the U.S. Economy is strong."
-Bies - FRB (See Article on Bloomberg)
"Except for Food and Oxygen, I have everything else I need to survive."
-SINGER
Posted by: SINGER | Mar 10, 2007 11:04:28 AM
Will a significant drop in consumer spending cause the crisis everyone's expecting? Or will a crisis, in some form, cause a drop in consumer spending?
Given how deeply ingrained 'shopping' has gotten in the fabric of American 'culture' I would bet on the latter.
First he eats his home equity, then his stock portfolio then...? Makes for a good version of PacMan does it not?
Posted by: Bluzer | Mar 10, 2007 11:08:00 AM
MEW ending along with the dead cat bounce? Maybe that's the noise a dead cat makes when the force of gravity takes hold once more of the overleveraged markets.
Posted by: lurker | Mar 10, 2007 11:12:18 AM
It is good to find out that the Law of Supply and Demand is still functional; it seems that demand has hit a peak, though, if the only way to add value is to reduce supply. Without a fresh money infusion, it will be difficult for demand to increase substantially, and for the past two weeks repurchase agreements have ebbed.
From where will new money come to create increased demand?
Posted by: Winston Munn | Mar 10, 2007 11:24:17 AM
Winston-from the sky and Ben's dollar-dumping choppers....ahhhhhh I love the smell of fresh currency in the morning!!!!
Posted by: lurker | Mar 10, 2007 11:35:24 AM
I know a lot of people bash him, but I heard Ken Fisher say this EXACT thing early last year on Bloomberg with Suzy Assad and suggested the market would do very well because of it. I wasn't sure whether to believe him at the time, but the chart is very illustrative (and it comes from Paul Kasriel). I was having a tough time believing companies and private equity could take so much issuance out of the equity market that it would acutally drive up stock prices. Now I know.
Posted by: Polly Anna | Mar 10, 2007 11:35:56 AM
the homebuilders and lenders have bought back tons of stock the past five years but that is unlikely to continue.
Posted by: seminole | Mar 10, 2007 11:43:26 AM
I tend to see buybacks as tax-advantaged special dividends. Tax-advantaged for obvious reasons, special since they likewise tend to be more volatile payment streams. What's going on with the market is simply that profits really have been that high as a percentage of GDP, and so corporations have been spitting out money. Check the charts I did based on the S&P data, especially the second one.
Now, if buyback activity stops going up like that, or if rates go up, or both, there will be less payout supporting market valuations. For now, though, the S&P 500 still represents a pretty good value proposition vs bonds, which is why I stayed net long through the recent market downdraft and actually went slightly levered long last week.
The market and the economy are vulnerable enough I took off that bet before the NFP came out, and I added back a couple select shorts on Friday in some of my target sectors, but I can't see being anything but net long while profits and payouts are high and rates are low so long as the 'soft landing' stays soft.
Posted by: wcw | Mar 10, 2007 11:45:03 AM
interesting, but stupid.
scale by the stock of equity outstanding, then come back and talk.
Posted by: curmudgeonly troll | Mar 10, 2007 11:59:15 AM
I'm with wcw here: buybacks are easily 2x more tax efficient. Also...
If a firm, ahem, aligns managment and shareholder interests by paying management with long-term stock and option grants, there is a big incentive to pay with capital gains rather than income: the tax situation is better, and the resulting comp doesn't appear in the company's financials.
Posted by: gorobei | Mar 10, 2007 12:14:03 PM
There is an interesting discussion of buybacks in an old but valuable book: "Quality of Earnings". (Not hyping the book - it's publication date was 1987).
"There are only two ways to increase earnings per share - earn more money, or shrink the number of shares....the latter is resorted to only when all else fails."
According to this source, the huge buyback bonanza we have seen bodes poorly for the future of earnings.
What's that whump, whump, whump I hear in the distance - could it be a the blades of a helicopter?
Posted by: Winston Munn | Mar 10, 2007 12:29:12 PM
One more thing worth considering...
"If MEW slows, that would potentially engender either more stock selling to fund a certain lifestyle -- or decreased consumer spending"
Slowing MEW also necessarily means a reduced supply of MBS related debt securities available for both domestic and foreign investors. The current account deficit continues to be financed, and the capital account surplus has to go somewhere. All else equal, this suggests an increase in demand for corp debt and/or equities, which could support buybacks for some time yet.
Posted by: Estragon | Mar 10, 2007 12:35:59 PM
ct's tone may have been annoying, but it's a good suggestion. Here's the chart as percentage of outstanding (PNG).
Looks like there has been one (1) period that competes with and in fact bests the current one: the late-'80s LBO boom time.
OK, ct -- get to talking.
Posted by: wcw | Mar 10, 2007 12:37:17 PM
Historically many/most Fortune 500 firms used "buy backs" to avoid dilution due to large stock option grants (MSFT, CSCO, etc.). Any analysis of the volumes of stock buy backs would have to be analyzed against the stock option grants to judge whether the buy backs were in fact reducing the outstanding stock of traded shares. Historically the buy backs resulted in no net reduction in shares.
Posted by: Paul Stanton | Mar 10, 2007 1:56:23 PM
I have to say - you guys are wonderful. I love these discussions. I only partially understand them, but gimme time.
The emotional me sees these buybacks and thinks why aren't they paying employees more? Isn't buying an employee like buying a car?
Then the rational me thinks, is this in fact a comment on the American worker? I guess this would be supported by the comment that buybacks are a last resort.
Scary.
Posted by: Aaron | Mar 10, 2007 1:58:19 PM
In the short run, this is bullish. In the intermediate term it is neutral-to-bearish. What to watch for:
1) Low IPO quality. (Does Clearwire count as a start? Perhaps it gets balanced out by Employers Holdings.)
2) Problems at private equity firms from low returns.
3) Declining gross margins at firms doing buybacks. Buybacks aren't magic; they only help firms that buy back stock below their intrinsic value.
4) Consumer spending is a red herring here. It doesn't affect the supply of stock. The most it does is change the motivation of a wealthy person short on cash to lift the bid, rather than wait at the ask.
Good post, though.
long EIG
Posted by: David Merkel | Mar 10, 2007 2:10:37 PM
There may be alot of IPOs on the forward calendar, but the bankers may have screwed themselves if the price action in a couple of large high profile deals this past week is any indication.
CLWR raised $600 million on Wednesday. It broke price the first day of trading. By close of business Friday, it was down 10% from it's offering price.
XFML raised $300 on Friday. It broke price during the first two hours of trading, and closed the day down 13%.
Posted by: S | Mar 10, 2007 2:29:20 PM
Don't forget my favorite fruit, FIG.
Posted by: wcw | Mar 10, 2007 3:15:19 PM
One other way to look at this is a straightforward trade-off between the cost of debt and the cost of equity, otherwise known as WACC optimisation. As the cost of debt goes down, expect fewer issues. If it goes way down, it makes sense for companies to reduce their equity outstanding. As borrowing rates go up, firms will slow or stop the equity repurchases.
The only tricky part of applying this is figuring out how the risk-weighting between asset classes plays out, but not many would disagree that issuing even risky debt has been extraordinarily cheap. Equity risk (volatility) may also be low, but nowhere near the massive compression in spreads between debt classes.
As noted elsewhere here, issuances as a percentage of outstanding is low, but at the margin can have a large effect. But this is all probably just a sideshow compared to the movement of money to a different asset class and the effects there: e.g. housing.
Posted by: Greg Alton | Mar 10, 2007 4:20:38 PM
Argument:
Buybacks are a use of corporate cash (e.g. from retained earnings). Cash generated and retained reduces the average risk level of assets, which reduces the cost of capital, with corresponding enhanced effect on PE valuation. Buybacks reduce such corporate cash levels, thereby increasing the average risk level of assets, compared to that had cash been retained. Increased risk then mean increased cost of capital, with corresponding depressing effect on PE valuation. The degree to which buybacks actually increase share price, compared to that had cash been retained, is debatable.
?
Posted by: JKH | Mar 10, 2007 4:37:34 PM
That corporations prefer to buyback shares instead of investing for the long term would have surprised me 2 days ago.
Now I am underwhelmed. Why? Because of a conversation I had yesterday with a retired very senior executive of one of the Fortune 100. The reason I stay vague about the gentleman ID is simple: he still does a good amount of consulting on the side, and is a rather private fellow.
What he told me was downright scary; essentially, very few public corporations engage the capital they used to in R&D. Anything that is not applied research deemed to generate marketable results as fast as possible is just shunned. Some private ones do have a time-honored tradition of NEVER skimping on R&D (Bose is a great example of that; SAS come to mind too) but publicly traded companies have markedly decreased their mid-long term R&D. It's a trend that scares the heck out of him.
At first, I was very skeptical and let him know it: How in the world did these guys expected to stay competitive in a knowledge economy without innovating? C'mon! Innovation takes TIME and resources. Plus, there are numerous studies that show how corporations that invest steadily in meaningful R&D end up beating the market in the long-term.
Aaaah! "Long-term" That was the key word. In his regular conversations with deciders, a dominant theme ("fixation" came into the conversation) is "efficiency". How can we extract the maximum value form our assets in the shortest unit of time? Some of his clients even have "efficiency experts" deployed in teams that scan every conceivable corner of their turf to scrub any behavior, process, physical stuff, you-name-it thing that is not "efficient".
Yes...but how are you going to innovate? ask the consultant to the execs. "We can always buy what we need, can't we" is a common answer. How's that for efficiency?
With such a mindset, it is not surprising that corporate purse wardens will go for what "works" in the most "efficient" manner possible.
Somehow, something important is missing in this picture.
Francois
Posted by: Frankie | Mar 10, 2007 7:56:30 PM
In other words, the psychology of the financially engineered buyback is a double-edged sword. If either the market seriously corrects or the economy slows (or both), we should expect buybacks to drop too.
Mr. R:
Although I have not reseached this, it would seem that exceptional buybacks would be a leading indicator for lowered economic growth expectations. If you consider business investment as levels, then level 1 would be investment in expansion of existing business, new products, new markets, and increased R&D - this is what you would expect if uninterrupted 3-5% GDP were anticipated for the foreseeable future. If level 1 is saturated, then Level 2 would be growth by acquisition, which in an isolated instance would not be significant, but if widespread could indicate a perceived lack of growth opportunity in the primary business. Level 3 investment would be buybacks - this would indicate that level 1 and level 2 options do not show as much promise for share performace as the simple expedient of reducing outstanding shares - hence, a expectation of slowing enomonic conditions.
Is there any validity to this common sense thinking?
Posted by: Winston Munn | Mar 10, 2007 8:52:45 PM
"Although I have not reseached this, it would seem that exceptional buybacks would be a leading indicator for lowered economic growth expectations."
See comments by G. Alton above. Buybacks alone don't necessarily imply reduced levels of investment for the economy as a whole. Money spent on buybacks can eventually flow back into the corporate sector through debt issuance. Also, earnings after dividends for the corporate sector as a whole may exceed buybacks - i.e. retained earnings may still be positive, financing investment. Portfolio adjustments at the micro level (e.g. specific corporate buybacks) don't necessarily translate to the same investment adjustment at the macro level. Finally, national investment actually exceeds national saving - the difference is the current account deficit. This demonstrates that there is still more than enough macro level investment to be financed, notwithstanding the micro level buyback behavior of some corporations.
Posted by: JKH | Mar 10, 2007 9:26:59 PM
