The incredible shrinking equity market

Stock markets everywhere are getting smaller. This is probably a good thing.

Look beyond the wallowing and schadenfreude that surrounds London’s dawning irrelevance and there’s much broader, quieter trend of de-equitisation afoot. Europe’s net buyback yield — that is, share buybacks net of issuance — has just turned positive for the first time in history, according to Bank of America research. The Stoxx 600 Europe has moved into line with the S&P 500, where repurchases have been outstripping issuance for a couple of years.

To be fair, it’s unlikely to last. While European equity issuance is low because the IPO window is yet to reopen, recent buybacks are being inflated by windfalls from energy prices and rising interest rates. BofA counts 52 new buyback programs announced by European large-caps so far this year, of which 17 are by banks and eight by energy companies. (Here’s the full list.)

As we reported in January, European companies were last year buying back shares more rapidly than those in the US for the first time in 20 years. The 2023 outlook is similar, even though at around 13 times earnings European equity valuations are back at the long-term average both in absolute terms and relative to Wall St.

Unusually big repurchase programmes are now mostly lag effects from fuel and rates: Europe’s banks and energy stocks are promising 12-month forward buyback yields of 3.4 per cent and 5.9 per cent respectively, versus nearly 2 per cent for the market as a whole, BoA finds.

“Paying shareholders to go away at the expense of those who remain” is a thing elderly markets types like to say about buybacks, often to the irritation of academics who study capital allocation. As our colleagues at Unhedged discuss, neither side is conclusively right or wrong. Figuring out whether a repurchase programme lowers the cost of financing, or whether it starves operations in the cynical pursuit of EPS-based management bonus targets, can only ever be judged on a case-by-case basis.

All of which brings to mind a famous 2009 note from James Montier, written in his final weeks as a Société Générale analyst, on “repurchase rip-offs”. He found that once adjusted for options issuance, net buybacks were just 30 per cent of announced US buybacks:

Many investors thought that repurchases were a substitute for dividends. We have long argued that they are primarily used to distribute transitory earnings and as such represent the most ephemeral engine of returns. [ . . . ]

Many were excited by the buyback boom in the latter half of this decade. To us, it simply represented a sign that earnings were at cyclical peaks, and firms were distributing surplus cash in a way which benefited corporate managers the most. All this leaves investors facing a double whammy of dividend cuts and vanishing repurchases.

Will the end of the free-money era echo its beginning? Maybe, but probably not. Corporate balance sheets seem to be strong enough to withstand the shallow earnings recession that is currently the base case. Repurchase programmes will roll over along with earnings growth, but dividend cover is healthy-ish so the returns double whammy described by Montier looks like less of a risk this time around. All charts below are via Barclays:

In that context, positive net buyback yields might be a welcome indicator. Maybe, at last, the balance of purportedly surplus capital isn’t being burnt just to offset options dilution and manipulate EPS.

Maybe a shrinking equity market is good — though from certain angles, it remains hard to shake the idea that European companies have been paying for shareholders to go away, at the expense of those who remain: