Sentiment Watch 2021: Share Buyback Edition

Judging by the financial news publications we read regularly, press coverage has become much more cheerful over the past several weeks, in our view. Where once commentators we follow seemed pessimistic, seeing reason after reason equities had come too far, too fast, we think they are now fairly optimistic. Market sentiment overall doesn’t yet appear euphoric, as expectations for the economy still seem broadly reasonable to us currently. However, we think parts of the market are becoming frothy, making sentiment’s evolution a key factor to watch this year. In this regard, we find recent shifts in attitudes toward share buybacks notable.

Share buybacks, as the name might imply, refer to companies purchasing their own shares. Many consider this to be an alternative way of returning earnings to shareholders (the other main way being to pay a dividend). According to the theory, a buyback makes the remaining shares more valuable by reducing the number of shares its market value, earnings and other metrics are spread across. All else held equal, that would raise share prices and earnings per share (EPS), although there are many more variables at work.

In years past, most coverage we follow has been sceptical of buybacks. Commentators we read often echoed many American politicians’ complaints that buybacks were a poor use of capital that rewarded shareholders at workers’ expense, or they argued buybacks inflated EPS artificially and made investors think companies were more valuable than they really were. Other arguments we encountered regularly included assertions buybacks were the only source of investor demand and, if they ceased, shares would stop rallying. We think those claims didn’t mesh with reality, but they appeared to help dampen sentiment—and keep the euphoria we think contributes to bull markets’ deaths at bay.

Now, with data showing buybacks recovering from last year’s COVID-related drought, we think the tenor has changed.^[i] One outlet we monitor suggested they are a positive sign of corporations’ confidence in their own long-term prospects—allegedly an overall bullish signal—and a sign investors shouldn’t read too much into corporate insiders’ simultaneously lower pace of buying.^[ii] (Whilst we don’t agree with that analysis, as our research indicates insiders’ transactions generally don’t determine shares’ direction, we found the change in tone noteworthy.) Another report we reviewed recently cheered the buyback rebound not only as a sign of healthy corporate balance sheets, but as an additional source of demand for already-booming markets.^[iii] We also think this is a notable change in the press coverage we normally view. Whereas before, commentators we follow would claim buybacks were the only source of demand keeping markets afloat, they now seem to acknowledge other positive factors supporting shares.

Warming sentiment toward buybacks isn’t inherently a reason for investors to be sceptical, as present expectations aren’t outlandish, in our view. But we have noticed one apparent shortcoming across articles we reviewed: They seemed to view buybacks in a vacuum without considering other share supply drivers. For instance, since the Bank of England gave banks the green light to resume share buybacks in December, commentators we follow think this will boost Financials shares. The problem with this, in our view, is that it doesn’t account for banks’ large new share issuance during the 2008 – 2009 financial crisis to meet higher capital requirements. When companies issue new shares, it dilutes shareholders—dividing the company’s total market value and profits by a greater number of shares, mathematically reducing the relative present and future value of each individual holding. We think buybacks from here would mostly just address that long-ago dilution.

In our view, share supply is important to monitor. Basic economics hold that prices move on supply and demand. If supply gets too high, unless demand keeps up, that theoretically leads to lower prices until equilibrium is restored. More broadly, we don’t think buybacks are the only supply driver on the rise lately. Initial public offerings (IPOs) are accelerating, with UK deal volume increasing 30% y/y and pound proceeds up 56% in 2020.^[iv] Across the pond, almost half of American IPOs in 2020 were from blank-cheque firms (formally known as Special Purpose Acquisition Companies, or SPACs) that go public solely to execute a reverse merger with a startup.^[v] In short, the SPAC raises capital through the IPO, then purchases a privately held startup. After the merger, the listing converts to the new company, enabling the startup to shortcut the traditional IPO process. We think keeping an eye on these as well as share-based mergers (mergers in which the buyer pays by issuing new stock, rather than using cash on hand) and share-based employee compensation will be critical to monitoring equity supply this year. If these categories collectively race far ahead of buybacks and cash-based mergers—and no one notices—then that is potentially a sign expectations for global markets’ near-term earnings potential are too far-fetched.

Again, we don’t think we are there yet. We are still seeing some sceptical coverage of initial and secondary offerings, which tells us investors haven’t forgotten that the possibility of diluted earnings exists. But if people have flipped so positively toward buybacks they don’t even take the time to find negative implications—from supply or otherwise—that could be a sign sentiment is firmly in the optimistic category. If all coverage of share supply turns uniformly sunny later this year or next, however, that might be one indication of euphoria eventually taking hold. So stay vigilant—in our view, monitoring the sentiment cycle is critical for assessing how likely reality will square with expectations and move markets going forward.