Sentiment Watch 2021: Stock Buyback Edition

If you have even merely peeked at financial news over the past seven weeks or so, you have likely noticed how much more cheerful press coverage has become. Where once pundits were pessimistic, seeing reason after reason stocks had come too far, too fast, they are now pretty optimistic. Not euphoric, as expectations for the economy seem overall reasonable currently, but we are starting to see small pockets where things are looking juuuuust a bit frothy, which makes sentiment’s evolution a key factor to watch this year. One example: sentiment toward stock buybacks.

In years past, most coverage of buybacks has been skeptical. If pundits weren’t parroting politicians’ complaints that buybacks were a poor use of capital that robbed Worker Petra to pay Shareholder Paulette, they were arguing buybacks were falsely inflating earnings per share and making investors think companies were more valuable than they really were. Or they groused that buybacks were the only source of investor demand and that once CFOs turned off the buyback machine, stocks would stop rallying. Those were all false fears, in our view, but they helped extend the proverbial wall of worry.

Now, with buybacks recovering from last year’s COVID-related drought, the tenor has changed. One outlet called them a positive sign of corporations’ confidence in their own long-term prospects—an overall bullish signal—and a sign investors shouldn’t read too much into corporate insiders’ simultaneously lower pace of buying.^[i] (Not that we agree with that thrust, as insiders’ transactions generally don’t indicate anything, but the tone is noteworthy.) Another 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.^[ii] Not the only source, not the one thing keeping markets afloat, but an added plus. That is … new.

Positivity toward buybacks isn’t inherently a reason for investors to be skeptical, especially because present expectations aren’t outlandish. But we have noticed one shortcoming across all of the articles we reviewed: They viewed buybacks in a vacuum without considering other stock supply drivers. For instance, ever since the Fed gave banks the green light to finally resume stock buybacks after last year’s stress tests, pundits have cheered it as a magic elixir for Financials stocks. The problem with this is that it doesn’t look back far enough. It doesn’t consider that many banks had to issue oodles of new stock during the 2008 – 2009 financial crisis in order to stay alive, whether of their own volition or as a condition for receiving (forced) government assistance. When companies issue new stock, it dilutes shareholders—market cap and total net income are divided by a greater number of shares, reducing the relative present and future value of each individual holding. We don’t think that is the only reason Financials lagged badly for the vast majority of the 2009 – 2020 bull market after an early pop off the low, but we think it likely played a significant role. Buybacks from here would mostly just address that long-ago dilution, putting a bookend on the crisis.

More broadly, buybacks aren’t the only supply driver moving fast lately. IPOs are booming, many from blank-check firms (formally known as Special Purpose Acquisition Companies, or SPACs) that go public solely to execute a reverse merger with a startup. Secondary offerings are running at a record-fast pace thus far in 2021, and not just from troubled airlines and hospitality firms desperately needing capital—Tech companies are also getting in on the action, leveraging investors’ enthusiasm to get more money to finance expansion. Keeping an eye on these as well as stock-based mergers and stock-based employee compensation will be critical to monitoring stock 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 Corporate America’s near-term earnings potential are too far-fetched.

Again, we aren’t there yet. We are still seeing some skeptical coverage of initial and secondary offerings, which tells us investors haven’t forgotten that the possibility of diluted earnings exists. But the fact people have flipped so positively toward buybacks that they don’t even take the time to find negative implications—from supply or otherwise—is a sign that sentiment is firmly in the optimistic category. If all coverage of stock supply turns uniformly sunny later this year or next, however, that might be one indication of euphoria eventually taking hold. So stay vigilant.