Sunday, September 30, 2007

Buybacks are all the Rage - Is the Market Inevitably Going Up in the Long Run?

After reading about the latest intent to buyback $15 BILLION worth of shares from Chevron (CVX) following an earlier announcement this summer from ConocoPhillips (COP) for the same amount; along with Exxon's (XOM) continuous buybacks, this set me to thinking. Is the market simply destined to go up because we don't have enough stock for people to invest in? Basic economics - supply (of stock) shrinking, demand steady (or rising), prices must go up.

Without getting into a debate of what is in the best interest of the American consumer i.e. should these companies be spending even more in capital expenditures to try to find more oil in more difficult (read expensive) manners (which would benefit many) or should these companies be spending the cash for corporate buybacks (which benefit far fewer, i.e. stock holders) - let's take a step back and look at the really big picture.

First, there is a lot of money sloshing through this world. And more of it is printed each day, especially petro dollars - see the rising billionaire class in Russia, Middle East, Far East. Think of it as a transfer tax - money going from the many (consumers) to the few (those who own petroleum). Or just think of the new riches being formed as more money is being circulated through this world as more middle class consumers are created in the Far East, South America, parts of Russia, parts of Middle East. The underlying fact is the money supply *is* growing, whatever the debate of how it is being created. And it wants to be invested. I think this is part of why the private equity (bubble?) is formed (forming?) and won't be going away. Ultra rich back these firms. So again, worst case scenario is a flat demand for assets and I'd argue that one could say an increasing demand for assets such as equities.

Second, let's look at the supply of US stock. Do you realize the level of buybacks that have been going on? Not announced buybacks but tried and true "after the fact" reporting of buybacks is >$100 BILLION for 8 quarters in a row. It has accelerated lately... $118 Billion in Q1 2007, and $158 BILLION in Q2 2008. Even if we drop back to low $100s for Q3 and Q4 2007 that is an annual buyback bing of just under $500 Billion. On top of that is 6 previous quarters (back half of 2005 and 2006) of another $600 Billion+. So this is $1.1 Trillion of stock value that will be taken out of circulation by year end 2007.

What does that number mean? Well I wanted to find out myself. So I went to look at some median capitalizations in the US market. (off on a tangent here - it is hard for the common man to find a nice table of market caps sorted from highest to lowest for the SP500!) I had to use the Russell 1000 and Russell 200 indexes and work backwards using their median market cap figures.

For the Russell 200 which are the largest 200 stocks in the USA, the median market cap (meaning the 100th largest stock in the USA) was 31 Billion. The smallest market cap (meaning the 200th largest stock in the USA) was 11.8 Billion.

Then looking at the Russell 1000 the median market cap (meaning the 500th largest stock in the USA) was 5.75 Billion.

So more simply
100th largest stock in US = 31 Billion
200th largest stock in US = 11.8 Billion
500th largest stock in US = 5.75 Billion

So last quarter alone (Q2 2007) companies bought back $158 Billion of stock. Now that was of course mostly done by the largest companies in the US (the true mega caps with >$100 Billion market cap) but it doesn't matter WHO is retiring this equity, it simply matters that it is being retired from the market as a whole. And when it is retired that means SUPPLY of stock in the US as a whole is falling. Of course some of this is offset by new IPOs and new stock options and restricted stock being sold but in general those are drops in the bucket save for the Google's (GOOG) and VMWare's (VMW) of the world. Let's acknowledge those facts but ignore them for now. (I don't have any great source to see how much new equity is 'created' each quarter, but would love to see it)

So if we retired on average say $110 Billion a quarter, that is essentially saying we are eliminating 10 huge companies the size of 200th largest stock in the US (market cap $11.8 Billion) So supply of stock equal to 10 of those companies are disappearing each quarter; or 40 a year. Or if we move down the scale a bit to the 500th largest company size, which is $5.75 Billion, we are eliminating 20 of those companies a quarter; or 100 a year. These are not tiny fish, these are companies at the bottom end of the SP500...

Again, 'some' of this is offset by new shares and IPOs but for every VMWare with >$25 Billion market cap (but only part of it is freely circulating in the float to be part of the stock 'supply'), there are 20 tiny $200 million IPOs which don't add much new supply to the market. Also balanced against these IPOs are private equity deals that take supply off the market.

So after looking at this, and knowing we have a global demand for equities, in part driven by governments enriched with petrodollars, along with newly minted billionaires/multi millionaires being created - along with a dwindling supply of product (i.e. stock) to be bought here in the US - is it simply inevitible that supply/demand dynamics point to ever increasing prices as long as cash flows allow our domestic corporation to buy back stock at such a staggering pace?

Any comments on what I am missing in this analysis would be welcome. If it's (relatively) sound one must ask how one cannot be a bull for the medium to long term, as this 'transfer' tax pulls money from consumers/workers and into pockets of employers, only to redeployed (along with massive gains from petrodollars) into stock buybacks.

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