Wasn't really looking to stumble onto a giant mess before bed but here we are. This all started by reading a pretty simple article in the Wall Street Journal (link below). Companies in the S&P 500 repurchased $234.5 billion in shares during the third quarter, topping the previous record of $223 billion in the fourth quarter of 2018, according to preliminary data from S&P Dow Jones Indices. The wave of share repurchases has helped propel U.S. stock indexes to dozens of records in 2021. The S&P 500 is up 25% this year, notching 67 record closes.
On the surface there's nothing wrong with buybacks. They increase shareholder's stake in a company by reducing the overall share count and are seen as a tax efficient form of returning equity to shareholders. Whereas dividends are taxed at regular income rates, buybacks do not create taxable events.
After finishing the article and looking through the links to other stories I see one that is talking about the record amount of insider selling that's been happening this year. So far this year, 48 top executives have collected more than $200 million each from stock sales, nearly four times the average number of insiders from 2016 through 2020. Across the S&P 500, insiders have sold a record $63.5 billion in shares through November, a 50% increase from all of 2020, driven both by stock-market gains and an increase in sales by some big holders. The technology sector has led with $41 billion in sales across the entire market, up by more than a third, with a smaller amount but an even bigger increase in financial services.
Again, there's nothing inherently wrong with insiders selling stock. Many, such as Elon Musk, are solely compensated in company stock. It's become commonplace for CEOs to avoid taxes by keeping their wealth tied up in company stock and then taking out loans against those holdings. Because they never actually sell the stock they never hit a taxable event and therefore never pay taxes. Eventually though they sell. Insider selling into strength is also not only common but smart. Executives often sell shares under advance trading arrangements, dubbed 10b5-1 plans, that trigger sales on a fixed schedule or at price thresholds to avoid running afoul of insider-trading rules. The plans were used in almost two-thirds of stock sales last year—up from 30% in 2004—but some investors and regulators worry they can be abused.
So maybe you're asking the same question I did. I get insiders selling into strength but why would they then turn around and recommend that their company repurchase shares at these high valuations? How common is this practice? Does it have any implications on the overall market?
In a 2017-2018 study, SEC researchers found that insiders were twice as likely to sell on the days following buyback announcements as they were in the days leading up to announcements. Their average sale was also five times larger than before the announcement, at about $500,000. At companies where insiders sell heavily, a later SEC analysis found, stocks delivered subpar returns in the long term. SEC rules do allow insider selling during a buyback, however. While many executives have prearranged procedures to sell stock, these plans do not have to be publicly disclosed and can be changed. It's also important to note that some insiders are in a position to decide the timing of a buyback announcement, meaning it could be set ahead of a prearranged sale, putting them in a position to benefit from any price rise.
The Securities Exchange Act of 1934 defines market manipulation as an illegal scheme in which people conduct transactions that create actual or apparent trading activity in a stock to induce others to buy or sell the shares.
But under a 1982 provision, the SEC gives companies special protection, a “safe harbor," from market-manipulation charges during buybacks so long as they abide by certain rules, including buying no more than 25 percent of a stock’s average volume on any single day.
Repurchases enrich executives in several ways. First, the value of insiders’ stock holdings stands to rise because buybacks reduce a company’s total shares outstanding and increase earnings per share, a closely watched investment metric that drives stock prices. The insiders also can get a better price for any shares they want to shed by selling into the buyback. And last, the higher earnings per share can enable them to pass thresholds in compensation packages that trigger higher bonuses and incentive pay.
So that's pretty obviously shady and self serving but not technically illegal.. some may argue it's not even a problem. Here's where another fact introduced into the mix starts to make things incredibly problematic. I'd like to direct your attention to the two graphs I've provided. The top graph shows share buybacks with an overlay of S&P 500 returns. Needless to say there's a pretty exact correlation. Below that you'll see a graph showing the rate of buybacks along with the rate at which companies are issuing debt. The proportion of buybacks funded by corporate bonds reached as high as 30% in both 2016 and 2017. When companies do these buybacks, they deprive themselves of the liquidity that might help them cope when sales and profits decline in an economic downturn. Another factor is that when companies are buying back shares they are by definition not spending that money on R&D. In fact, in 2018, only 43% of companies in the S&P 500 Index recorded any R&D expenses, with just 38 companies accounting for 75% of the R&D spending of all 500 companies. Whether or not a firm spends on R&D, all companies have to invest broadly and deeply in the productive capabilities of their employees in order to remain competitive in global markets.
Buybacks’ drain on corporate treasuries has been massive. The 465 companies in the S&P 500 Index in January 2019 that were publicly listed between 2009 and 2018 spent, over that decade, $4.3 trillion on buybacks, equal to 52% of net income, and another $3.3 trillion on dividends, an additional 39% of net income. In 2018 alone, even with after-tax profits at record levels because of the Republican tax cuts, buybacks by S&P 500 companies reached an astounding 68% of net income, with dividends absorbing another 41%. We've surpassed these previous records this year.
So let's piece it all together. Companies are issuing debt in order to buyback shares which drives up share prices and inflates EPS. Insiders who are overwhelmingly compensated with stocks are then using the effects of these buybacks to increase their wealth with a consequence of increasing the debt load and lowering the money reinvested into their companies. This feeds into a cycle of boom/bust where companies take on too much debt and inevitably the market reacts by dropping share prices when the debt financed buybacks are slowed which negatively affects EPS. Also the money not spent on research and development will over time erode the competitiveness of the company.
This is a disturbing trend. What typically comes after the boom? Well we're about to find out exactly what happens when the Fed raises interest rates. This will increase the cost of borrowing which will inevitably reduce the total number of buybacks companies are able to finance. You can see from the chart the near exact correlation between share buybacks and the S&P 500 price level. This is clearly something that we as investors should be aware of. I would pay special attention to announced repurchase agreements to see if the pace starts to slow. Insider selling would also slow according to historical precedent. When the levels of these two starts dropping I would expect to see the market drop very soon afterwards. It's impossible to pinpoint a decline exactly but when you factor in all the evidence I've provided it seems paying attention to these levels could help you avoid one type of market decline. What are your thoughts?
Sources
https://www.wsj.com/articles/buybacks-hit-record-after-pulling-back-in-2020-11639263140
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https://www.wsj.com/articles/elon-musk-other-leaders-sell-stock-at-historic-levels-as-market-soars-tax-changes-loom-11639089782
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https://hbr.org/2020/01/why-stock-buybacks-are-dangerous-for-the-economy
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‘Most Americans Today Believe the Stock Market Is Rigged, and They’re Right’ https://www.bloomberg.com/news/features/2021-09-29/is-stock-market-rigged-insider-trading-by-executives-is-pervasive-critics-say
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# # # #tcardizzle #insidertrading #buyback
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