This In Practice piece gives a practitioner’s perspective on the article “Net Buybacks and the Seven Dwarfs,” by Jean-Francois L’Her, Tarek Masmoudi, and Ram Karthik Krishnamoorthy, CFA, published in the Fourth Quarter 2018 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Some investors view the economic growth of a country/region as a good predictor of stock market returns, and this perceived correlation between growth and returns can have a big influence on their asset allocation decisions.
But it is far from clear that stocks in the fastest-growing economies perform better than stocks in the slowest-growing economies, and vice versa. Globalization and the consequent ability of multinationals to produce and sell outside their domestic markets is one reason. Another is that investors can get too excited by raw growth data and overpay for companies in expanding economies.
The authors aim to shed light on the “growth enigma” and also assess the main drivers of stock market performance, such as stock buybacks and issuance.
How Do the Authors Tackle the Issue?
The authors evaluate data from 43 developed and emerging markets over 21 years (from the start of 1997 to the end of 2017). To evaluate the contribution of net buybacks to stock market returns, they break down returns into their various components.
Given that dividend growth has been shown to be the main driver of stock prices, the authors focus on which aspects of dividends are the best predictors of real returns: the dividend yield, changes in multiples, or dividend per share (DPS) growth.
They then analyse the evident gap between DPS growth and GDP growth, which they term the “DPS gap,” and link this gap to the evolution of stock returns.
The authors further decompose the DPS gap into changes in profit margins, changes in payout policies, and a sales per share (SPS) gap. Arguing that the DPS gap is muddied by the difference between the top line (sales) and the bottom line (dividends), the authors explore the effects on stock market performance of sales per share (SPS) and split the “SPS gap” into two components: net buybacks and relative dynamism. SPS may, the authors argue, be more reliable than DPS because profit margins can be massaged and payout policies are discretionary. Analysing SPS enables the authors to identify changes in both payout policies and profit margins.
Lastly and, as it turns out, most importantly, they weigh the importance of net buybacks to stock market returns, comparing the effects of net buybacks with dividend yield, real per capita GDP, the price-to-dividend ratio, changes in profit margins, changes in payout policy, and relative dynamism.What Are the Findings?
Net buybacks explain 80% of returns over the last 21 years, putting the seven other variables assessed in the shade. The increasing number of buybacks globally, the authors note, has led to a positive correlation in many markets between stock market returns and net buybacks.
The authors report only a weak relationship between DPS growth and economic growth. The fastest-growing economies have clearly not enjoyed the highest stock market returns, and slow-growing economies have not all suffered poor returns.
The authors argue that the weak correlation occurs principally because shareholders in listed companies do not capture the economic growth of the market as a whole since new companies, which are more dynamic and have higher growth rates, are constantly being created. There is, the authors declare, a clear “DPS gap.”
This DPS gap, they find, explains the vast majority (98%) of the difference in returns between individual companies and the stock markets on which they are listed. GDP per capita growth—widely believed to be important in stock market performance—is only a small part of this difference.
Furthermore, the analysis of SPS reveals that changes in payout policy (dividends and buybacks) represent 0.5% of the returns from the 43 stock markets and profit margins, 1.2% of the returns. This result indicates a gap of SPS to GDP (the “SPS gap”) of 1.7%, which the authors ascribe to the dilutive effects of net issuance.
What Are the Implications for Investors and Investment Professionals?
The relationship between economic growth and equity returns is critical to top-down asset allocation decisions.
Investors’ country/region allocations may overlook the effects on equities of net buybacks. Over the past two decades, net buybacks have been a major differentiator between high- and low-performing stock markets.
The authors do not try to make forecasts for the various markets based on this critical performance driver, but they do point to the potential benefits of trying to forecast net buybacks. Over the last two decades, they say, issuance has outstripped buybacks globally. On average, this is clearly dilutive for stocks. However, 11 markets have seen more buybacks than issuance, including the United States.
The authors suggest near-term opportunities in the world’s two largest economies related to net buybacks. In the United States, they estimate that tax changes may increase buyback activity by around 50%, as companies repatriate cash from overseas and also benefit from stronger earnings growth and corporate tax cuts. These factors should be accretive to US stock market returns.
In China, meanwhile, net buybacks could be influenced by three factors. First, more IPOs are expected as the economy expands. Second, the benchmark MSCI China Index has yet to include all the large high-tech companies—such as Alibaba—which are listed overseas. Third, from June 2018, China A-shares started to be included in the index and could eventually represent around 40% of MSCI China.
All these factors will increase net issuance in China’s market and dilute returns. Although economic growth will be a key driver of returns, so will net issuance for existing shareholders.