On cash returns and de-equitisation | FT Alphaville

On cash returns and de-equitisation

Towards the end of last year, we had the vague notion that corporate buybacks were one of the factors holding up equity prices in 2011 while fund flows exited and other types of traditional investors stayed cautious.

At the very least we were aware that corporate buybacks had climbed back near the record levels of bubblicious 2006 and 2007.

And we assumed this was simply part of the Companies don’t want to expand given economic uncertainty and M&A remains subdued, so what else are they gonna do with their massive cash hoardes? story.

But this chart and commentary from JP Morgan approach the issue from a different angle — click to enlarge:

What JP Morgan finds is that while buybacks (and dividends) may have been historically high in absolute terms, the amount of cash returned to shareholders by corporates was actually quite low relative to what would be expected given the level of corporate profits. (An obvious point in hindsight that we just hadn’t considered.)

And not just when compared against 2007, as in the chart above.

The analysts make the case that the improving economic outlook means you can expect corporates to make up for last year’s gap — emphasis ours, and click to enlarge the chart:

We compiled all stock activity for all 15,000 U.S. companies that are publicly traded (even those no longer trading) and plotted the data in Figure 23 below.

  • — Corporate cash return as a percentage of profits (we used NIPA corporate profits for this exercise, which is a fairly comprehensive measure of corporate net income) is currently about 41% of profits—among the lowest levels since 1990 and well below the 20-year average of 51%.
  • — As noted in Figure 23, during the later years of an expansion, this figure has tended to rise to 65-80%. In 2007, companies distributed 78% of profits via buybacks and dividends, and in 2000 distribution totaled 84%.
  • — In dollar terms, this implies a buyback level in the range of $1.1-1.2 trillion, up substantially from $880bn currently.

An increase in corporate buybacks of $300-400bn is no different than a similar increase in the dollar amount of inflows fromretail mutual funds. This would be equal to the largest single year of inflows into equities by mutual funds.

The immediate possibility of a bump in cash returns — if previous patterns and JP Morgan’s assumptions about economic growth hold up — is probably the most relevant point here for investors.

We’re not so interested in the extrapolation, and we certainly try to avoid predictions for where equity markets are headed because how stupid do we look so many factors can play a role.

But we do plan to start following buybacks a little more carefully for a different reason.

Citigroup released an intriguing report in November on de-equitisation, finding that it has becoming a global trend (we’ve chucked the report into the Long Room).

In the US, although recent level of buybacks may not be what you’d expect given profit levels, it’s still climbing at a time when the IPO market has been stagnant and, possibly, is in secular decline. Meanwhile, secondary issues have only been prominent among financials seeking to raise capital.

Maybe all this will change in the (distant? distant-ish?) future, IPO markets will rebound and companies will decide they’ve done enough buybacks, shifting instead to capital investment and hiring. If so, rates will rise and make it no longer possible for companies to play the debt/equity carry trade, and equitisation will pick up again.

We don’t know. But we wonder what the longer-term implications are for public markets if the trend does continue.