Warren Buffett Not a Prophet Yet When It Comes to Stock Buybacks

(Bloomberg Gadfly) -- Wall Street says corporate America is finally taking Warren Buffett's advice on stock buybacks seriously.

Buffett, who once again will welcome tens of thousands of loyalists this weekend in Omaha for Berkshire Hathaway's annual meeting, has long warned that buyback-happy executives often destroy shareholder value by repurchasing their shares for more than they are worth. In this year's annual letter, Buffett partly defended buybacks. Some have called them earnings manipulation. Buffett doesn't agree, but once again said boards, either because they're chasing short-term gains or trying to hide huge stock grants to corporate executives, hurt long-term shareholders by executing buybacks at frothy market prices.

Now share buybacks, after years of increases, have been dropping recently. Repurchase activity slowed last year and is down drastically in 2017 to the slowest pace in five years. S&P Global Indexes reports that based on the third of companies in the S&P 500 that have reported results so far, the amount of money being spent on buybacks has fallen 23 percent in the first quarter compared with a year ago. Bank of America, based on its own proprietary survey, says buyback activity could be down as much as 30 percent.

Decline in Buybacks in 2017

23% to 30% 

Compounding the problem is that stock prices were 19 percent higher on average during the first quarter than a year ago. Less money spent at higher prices means that the actual number of shares being bought back will fall even more.

In a note to clients last week, Goldman Sachs's chief U.S. equity strategist David Kostin said that the "infatuation with buybacks has ended for both companies and investors." The reason, Kostin says, is price. "Experience shows that firms repurchasing shares at extremely high valuations regret those actions."

If that's that's the case, it would be a first. Executives and boards have shown little sensitivity to price in the past. For example, share buybacks peaked in 2007, when stocks were near their most expensive before the financial crisis. Buybacks were almost nonexistent in 2009, which was in retrospect the exact time to buy.

Either way, the drop-off in buybacks could be a problem for stock prices. Investors typically value shares based on earnings per share. And buybacks, which reduce share counts, have been providing a good portion, as much as 2 percent annually, of EPS growth recently by shrinking the denominator. That's because net income growth for the market as a whole has basically been nonexistent in the past two years. Profit growth has rebounded this year, in part because of the friendly comparisons of 2016. So the lack of a boost from share buybacks may not be as big of a deal this year.

Next year, however, it might be. Based on the S&P 500 current level of 2,391 and expected earnings, it appears investors are looking for continued EPS growth of 6 percent after inflation. Bank of America says the contribution from buybacks could drop to 1 percent. That means real corporate earnings will have to jump roughly 5 percent. In an economy growing at 2 percent, and with profit margins at historic highs and pressures on wages growing, that will be tough. 

Never fear, though. Some Wall Street strategists see a buyback savior in the form of Donald Trump. Most believe that by the end of 2018 the president will be able to push through a tax deal that will encourage companies to repatriate cash from overseas. Goldman's Kostin predicts that at least $150 billion of that cash will go to buybacks. Bank of America says such cash-fueled buybacks could add as much as 3 percent to EPS growth in 2018.

But those predictions seem to contradict the sudden discovery of price discipline. If boards and executives have truly gotten religion about not paying too much for their own shares, it's not clear why they would agree to a flurry of buybacks just because they have the cash, especially because the passage of any Trump tax plan would likely push stock prices up further.

Still, there are reasons to believe buybacks will rebound. One answer could be that corporate executives just don't have a choice. The implied earnings hurdle looks too high to clear without buybacks. Second, the idea that Buffett's long-term thinking has finally invaded corporate American board rooms and executive suites may be wishful thinking. The markets were falling in the first quarter of 2016, prompting executives to step up buybacks to shore up their stock prices. That may be why stock buybacks now, when the market has been relatively calm, look dried-up by comparison.

Buffett will have his bullhorn and investors' ears this weekend, and he may again decide to sound off on buybacks. He may not be preaching to the converted just yet. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

To contact the author of this story: Stephen Gandel in New York at sgandel2@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.