Buybacks Fizzle - Bezek's Daily Briefing

by: Ian Bezek


Stocks continue grinding higher; I'm not eager to short things yet.

Active large-cap funds are having their worst year since 2003.

Buybacks in specific are the source of much of the shortcoming.

More generally, funds are copying each other too much, rather than generating their own unique ideas.

After a quiet and mixed day of trading yesterday, stocks appear set to make a push to fresh new highs. With Japanese and European shares both more than 1% higher, there's a positive sentiment that appears set to push US shares to fresh highs. At this hour, S&P futures are up 8, and the Dow Jones futures contract has topped 18,500 for the first time.

On the bullish side of the equation, Microsoft (NASDAQ:MSFT) helped the market's mood with a solid earnings report. Despite slow uptake on installations of Windows 10, the company beat, driven by strength in its cloud platform (up more than 100% y/o/y). The long-awaited move to become less dependent on Windows and Office appears to be bearing fruit.

Internationally, the British Pound (NYSEARCA:FXB) has rebounded strongly this morning as it continues to see elevated volatility post-Brexit. Outside of the Pound, however, the US Dollar (NYSEARCA:UUP) retains its strength. It's moving newly higher; the dollar now sits at its highest level since March. With more Fed hike chatter on the way, look for the dollar to make a big push higher here as it breaks out. This will be a big negative for earnings and stocks in the back half of the year.

Crude oil (NYSEARCA:USO) continues to languish around $45 despite the enthusiasm for risk assets just about everywhere else. And gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) are finally starting to fade as the perceived need for risk hedging fades.

I'd note that the Chinese Yuan continues to slide quietly. The market has a habit of ignoring this and then suddenly deciding it is important again and starting to panic. Last August brought the first big devaluation sell-off. Perhaps we're due for another next month as August rolls back around?

All is not well with this equity rally from a fundamental perspective, but there's generally nothing good to come from shorting dull markets moving higher during the summer. Volatility (NYSEARCA:VXX) (NYSEARCA:UVXY) is still being aggressively bought by people wanting to fade this rally.

There was an especially large premium in volatility futures versus the spot VIX index this week, suggesting a large speculative bet on volatility rebounding in the near term. I have a sizable short position in VXX at the moment - if you're betting against the bull here, I think you're a month early.

Even More Funds Underperforming; Buybacks To Blame

A provocative article from Bloomberg suggests that large-cap fund managers are running out tools in their workbench. According to analysis from Bank of America research, only 18% of large-cap funds have beat the index in the first half of 2016; that's the worst tally since 2003.

They lay the particular blame for this new performance low on the fading impact of share buybacks and takeovers. As Bloomberg's table notes, buybacks have been underperforming the market lately:

Between 2011 and 2013, the companies most aggressively buying back stock beat the market with ease. 2013 was a particularly impressive year, with the most active share repurchasers beating the market by a stunning 20%.

In 2014, the trend flipped, with share repurchasers lagging the index slightly. In 2015, the performance gap widened, and 2016 year-to-date shows companies running aggressive buybacks down for the year versus a 5% gain for the index.

We can theorize that this is due to the relative valuation at which companies purchased shares. Between 2011 and 2013, valuations were generally reasonable, so a company buying back stock got a pretty big impact on its money. There's a huge difference buying back stock at 15x earnings versus 25x earnings when it comes to how it will impact shareholder returns going forward.

Recently, buybacks are being used as a form of massaging earnings at companies where top line revenue growth has ground to a halt. IBM (NYSE:IBM) is the usual whipping boy. It has papered over four years of corporate stagnation with an aggressive buyback that keeps EPS looking healthier. In IBM's defense, its shares are still attractive on a free cash flow and P/E basis though.

Where this phenomenon is really bad is with the stalled-out consumer products firms. Clobbered by the stronger dollar, they can't do much expansion abroad, and the developed markets are tapped out - there's little room to push through price increases as consumer spending remains muted.

Look at Colgate (NYSE:CL), where revenues and EBITDA have been essentially flat since 2008. The company can only grow earnings at this point by buying back its own badly overpriced shares. Look at this, the company's market cap has doubled since 2008 while revenues have gone absolutely nowhere:

CL Revenue (Quarterly) Chart

CL Revenue (Quarterly) data by YCharts

The company's EV/EBITDA ratio is into the 20s now, and the P/E ratio (even accounting for one-time events) has moved into the 30s. There's no growth story here - why pay 30x earnings for a company with a stalled out business? Colgate should be paying a bigger dividend rather than buying back shares, and to the extent that companies like Colgate lead the buyback charge to push EPS higher without improving the business, it's no surprise that buybacks are no longer inspiring the market.

As a general rule of thumb, if you don't want to be purchasing more shares of a company within a reasonably close level to its current stock price, you probably don't want management to be on an aggressive buyback spree either.

I don't hate active fund management as a class; markets are inefficient and there's a place for people that engage in independent thinking to beat them. However, as this bull market has aged, the big funds have by and large plowed into the same few popular ideas, and the well is running dry. As Bloomberg notes:

Another issue has been a particularly bad year suffered by stocks that are owned by the most funds. Manager favorites have been pummeled: the 10 most crowded stocks lost to the 10 most neglected stocks by 18 percentage points, an usually high spread, data from Bank of America show.

You can only push ideas such as buybacks or shareholder activism to a certain point; they aren't cure-alls that boost shareholder returns in all or even most situations. Active funds need to generate more of their own ideas rather than copying the same few ideas that have spread like a virus through fund-land. Overused strategies lose their luster.

Disclosure: I am/we are short UVXY, VXX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long IBM.