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Total Returns Matter

By Andrew Milligan Obe, Head of Global Strategy

Media reports of stock-market performance have one main problem. As they concentrate on the ups and downs of share-price movements, they rarely tell us about total returns.

Most investors know that companies usually pay them a dividend in return for buying their shares. In a world of ever-lower interest rates, dividends are attractive in their own right. The UK has, historically, been a high-yielding market, and it currently yields over 4%. This is more than double the yield from the big US firms. In recent years, other markets have begun to shift towards higher dividends too. Japan and Asia now yield more than 2%, and Europe more than 3% – hence the popularity of equity-income funds among some investors.

Dividends are not the only way in which companies can reward shareholders, however. Share buybacks are another important method. These matter a lot in the US, which amounts for around two-thirds of global buybacks. But they are important in the UK too, and they’re becoming more of a feature in Europe and Japan.

Some buybacks relate to one-off events – for example, when a firm returns capital to shareholders after a big deal. In the US, however, businesses routinely switch share-buyback programmes on and off depending on their share price, the state of the business and the incentives for management. Buybacks can add up: this year, the US is on course to return well over $800 billion of capital to shareholders in this way, with the technology sector particularly active. A technical term for this phenomenon is ‘de-equitisation’. Put simply, it means the total number of shares in a stock market is falling, not rising.

At certain times, businesses also look for cash from investors, leading to ‘re-equitisation’ through the issue of new shares. For example, Tesla has carried out a series of capital-raising offerings to fund its programme to build electric cars. These events increase the number of shares in circulation. But many firms prefer not to invest in large capital projects at present. The perception is that there is too much risk in the world economy.

Business models are changing too. Technology allows a capital-light approach, with companies hiring clever software talent rather than investing in costly plants and factories. Firms are also taking longer to demonstrate strong growth. Last year, the number of initial public offerings in the US was half the level at the start of the century.

These trends have accelerated the de-equitisation process. Until 2003, the equity markets in the major economies were generally adding to the net supply of shares. Since 2011, a shrinking net supply has been the order of the day. Over 2% of the US stock market was redeemed since the start of 2018. And while de-equitisation is more subdued in Japan and Europe, it is picking up noticeably.

Share buybacks are not the only route towards de-equitisation. The number of companies for an investor to buy can be reduced by merger and acquisition (M&A) activity. Since the start of 2018, the UK stock market has shrunk by 3%, mostly via such takeovers. Politics has accelerated this process. Following the UK’s Brexit vote, the pound has fallen to a much lower level. This has given overseas investors a one-off advantage in buying UK assets.

A frequent accusation is that financial engineering is a major reason for de-equitisation. After all, equity is much more expensive for a firm to finance than debt, which can encourage companies to borrow to buy back their shares. But there are broader issues too. Stock buybacks often reflect high levels of internal growth and cash generation. And managements can sometimes be sceptical of the benefits of public equity markets – perhaps because of activist shareholders or regulatory risks or public scrutiny.

For these reasons, many companies are taking the opportunity to go private. This may be an unintended consequence of central banks’ quantitative-easing programmes. In pursuit of higher returns, pension funds are flooding cash into private assets. This means that private-equity managers have plenty of money to bid for companies – which may have troubled business models but also the potential for turnarounds. All in all, the number of US-listed public companies in 2016 was about 75% of the total in 1976.

What does all this mean for total returns? In the past 15 years, the global stock-market index has risen 107% in price terms. But when all these other factors are taken into account – dividends, buybacks and M&A effects – the total return for holding global equities has been 205%. Interestingly, at the stock level, there is evidence of a buyback-return premium in global equities. Since 1995, high-buyback companies have generally outperformed those with low buybacks.

So, rather than merely paying attention to share prices, long-term investors should dig deeper into how companies generate cash and how they put it to work. This, along with the broader trends in re-equitisation or de-equitisation, will give useful signals as to where the best total returns are to be found.

Disclosures:

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