Losing a tailwind: the supply of equities may soon stop shrinking
WHEN supply falls and demand is strong, prices tend to go up. So it has been in America’s stockmarkets. Short-term interest rates at record lows and minuscule yields on government bonds have boosted investors’ demand for equities. And thanks to share buy-backs, the supply of shares has been steadily falling.
BCA Research estimates that the number of shares in issue on American stockmarkets has fallen by 6% since 2009. This tailwind for share prices, however, may be starting to fade.
A few decades ago many firms deliberately kept a bit of cash on their balance-sheet as a “rainy-day fund” to help them cope with recessions. That has gone out of fashion, partly due to pressure from activist investors. If firms have no better use for their money, the argument runs, they should return it to their shareholders
Share buy-backs also help improve a number of financial ratios. Especially at current interest rates, companies earn a low return on their cash. So buying back shares barely dents the company’s total earnings, but reduces the number of shares; earnings per share rise. The same arguments apply to measures such as return on assets.
Buy-backs can push up share prices in the short term and help executives meet the targets on which their bonus schemes are based. They also offset the equity issuance represented by managers’ options. Dividends don’t have the same impact. Increasing the dividend is also a long-term commitment, whereas a buy-back programme can be temporary. Cutting the dividend is a big announcement that can have an adverse impact on the share price. Scaling back a buy-back programme is less embarrassing. Small wonder that executives prefer buy-backs.
But are buy-backs a good thing for the economy as a whole? One reason why the Federal Reserve has kept interest rates so low is to encourage businesses to invest. Corporate profits are close to a post-war high as a proportion of GDP, suggesting that there are lots of profitable opportunities for companies to exploit. But although business investment has risen to 13% of GDP from a low of 11% during the recession, it has not regained previous pre-crisis heights. Money that might have been invested in new plant and equipment has been diverted into buy-backs.
There are tentative signs, however, that enthusiasm for buy-backs may be waning (see chart). In the first quarter of this year, companies spent $144 billion on share repurchases, down from $159 billion in the first quarter of 2014. The most likely reason for the slowdown is that profits have run out of steam, so firms have less cash to deploy. Forecasts suggest that earnings per share declined by 3% in the second quarter compared with the same period of 2014. Some of this is the effect of a lower oil price on the earnings of energy companies; some if it is down to the strong dollar, which reduces the value of multinationals’ foreign earnings. But causality also runs the other way: fewer buy-backs contribute to shrinking profits, since buy-backs boost earnings per share.
There has always been an element of financial engineering about buy-backs. Can it really be good news if a firm feels it has nothing better to do with its money? An enthusiasm for buy-backs creates the sense that executives are more interested in short-term share-price performance than in the company’s long-term health.
Further evidence of financial engineering comes from Andrew Smithers, an economist, who finds that, since 2000, the profits of listed companies have become four times more volatile than corporate profits as calculated in the national accounts. In his view, listed firms overstate their profits. Some investors argue that accounting standards have improved over the decades, reducing uncertainty; accordingly, shares deserve a higher valuation than before. But Mr Smithers’s calculations suggest accounting standards have deteriorated, not improved: if profits are more uncertain, equities should be afforded a lower, not higher, valuation.
There is another factor to consider, too. Last year was the biggest for new issues on America’s stockmarkets since 2000, with 288 companies listing, raising a total of $84 billion. Private-equity firms have been offloading investments, selling $73 billion-worth of shares in the first half of the year, according to Bloomberg—a record for a six-month period. Most of these were stakes in already-quoted companies, rather than new issues.
With the markets near a record high, it is no surprise that a few investors are taking profits. When prices are high enough for long enough, new supply will appear.