Photographer: Andrew Harrer/Bloomberg

Goldman: Investors Aren't Rewarding Share Buybacks Like They Used To

A potential headwind for equity markets.

A big component of the run-up in the stock market might be slowing down.

Years of low interest rates in the post-financial crisis era have encouraged Corporate America to borrow from the bond market to pay their shareholders through stock buybacks.

That's helped fuel new highs in the stock market while earnings have largely struggled, but analysts at Goldman Sachs Group Inc. say that the days of equity investors rewarding companies for such buybacks may be moving behind us.

"Investors have rewarded buybacks for many years but the pattern has reversed in 2016," the team, led by Chief U.S. Equity Strategist David Kostin write. The bank's proprietary buyback basket — comprised of stocks with the highest share repurchases over the past four quarters — has lagged the wider market year-to date, bucking an historic trend that has seen buyback-friendly companies outperform on an annual basis.

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Source: Goldman Sachs

Companies that have been repurchasing their shares have underperformed so far this year as investors seek the safety of dividend stocks and government debt, the Goldman analysts argue. "During periods of low growth and low interest rates, firms with the highest buybacks fail to provide investors with either the consistent yield of bond-like assets or the prospect of future growth," they write.

Meanwhile, the pace of buybacks appears to be slowing even as share repurchases by S&P 500 companies totaled $163 billion in the first quarter of the year — the highest level since the third quarter of 2007, according to Goldman data. However, the rate at which buybacks are being executed declined by 18 percent in the second quarter, compared with the same period a year earlier.

Increasingly high valuations are likely making it less attractive for companies to buy back their own stock, Kostin & Co. posit. Their calculations show that the median stock in the S&P 500 is sitting at a price to earnings ratio that is in the 98th percentile of the past four decades, and 40 percent of the index has hit a five-year high since the start of the second quarter. If buyback volume does decrease, the team sees this as a reason to think stocks will struggle to keep moving higher in the near term. 

"A slower pace of buybacks is a headwind for higher share prices given that corporate repurchases are the largest source of U.S. equity demand," they write. "We expect mutual funds, foreign investors, and pension funds will be net sellers of U.S. stocks in 2016."

Analysts at Citigroup Inc. also predicted a slowdown in buybacks late last year due to an eventual, if slow, rise in interest rates and a potential turn in the credit cycle that could make it harder or more expensive for companies to finance repurchases by borrowing. With corporate indebtedness on the rise, the Goldman analysts recommend investors look at companies returning cash to shareholders in other ways.

"Managers should focus on firms returning cash to shareholders via dividends," they said. "Low, albeit rising, interest rates, a recovery in dividend growth expectations, and modest economic growth should benefit this strategy in [the second half] 2016."

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