Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

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packer16
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Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by packer16 » Wed Sep 11, 2019 1:57 pm

One recent study (Net Buybacks & the Seven Dwarfs) showed that one of the most significant factors in cross sectional international returns was stock buybacks. It was almost 10x more important than any other factor over the period studied (1997 - 2017). However, this point is not included in any of the long-term forecasts of US & international stock returns.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by vineviz » Wed Sep 11, 2019 2:40 pm

packer16 wrote:
Wed Sep 11, 2019 1:57 pm
However, this point is not included in any of the long-term forecasts of US & international stock returns.
I can see how you might infer this from the paper you read, but it's not actually true. Very few "professional" forecasts are using the naive DDM model to forecast returns in the way that Straehl & Ibbotson suggest, and many are in fact explicitly incorporating net buybacks as a driver.
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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by packer16 » Wed Sep 11, 2019 2:52 pm

Given the large impact found in the study, it would be interesting to see if they had a raw forecast based upon let say valuation & how much that was adjusted by the "buyback" factor. The study results could imply that "buyback" factor could more than overcome the valuation differences between the US, international & EM. Do you know how they explicitly incorporate this into their forecasts & the magnitude of the changes from a raw valuation model would be. TIA.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by firebirdparts » Wed Sep 11, 2019 9:56 pm

I can tell you this: I would not want to be responsible for predicting the future amount of stock buybacks. If anybody is ignoring that, my bet would be they don't want to predict the future of it.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by Northern Flicker » Wed Sep 11, 2019 11:42 pm

The solution is to discount back net revenue instead of the distribution of it to shareholders (which can be in the form of dividends or buybacks). I think executives prefer buybacks to dividends because they are mote tax efficient for the shareholder, and corporate executives are in high tax brackets.
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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by vineviz » Thu Sep 12, 2019 6:40 am

packer16 wrote:
Wed Sep 11, 2019 2:52 pm
Do you know how they explicitly incorporate this into their forecasts & the magnitude of the changes from a raw valuation model would be. TIA.
Unfortunately, it all boils down to who "they" are. Every firm that publishes market forecasts has their own methodology, and you'd need to go through the details of each one to figure what additional adjustment for buybacks (if any) would need to be made.

BNY Mellon, for instance, already explicitly includes net buybacks in their valuation model. link

The Vanguard Capital Markets Model is a risk-based model (using both macroeconomic and financial market risk factors for each asset class and geography) and therefore doesn't require any adjustment for net buybacks or dilution. link

Research Affiliates, which is Rob Arnott's firm, on the other hand uses two different forecast models. They use both a valuation model (which would not be affected by buybacks) and a yield growth model (which uses only dividend yield, AFAIK, and would therefore be a target of the criticism that Straehl & Ibbotson were leveling). link Even there, though, they do apply a dilution correction factor when doing market-level forecasts but there is some question about who accurate it is. Straehl & Ibbotson specifically call it out as being theoretically questionable (because it basically just assumes a constant 2% dilution rate, without accounting for the variability in buyback rates) but note the final forecasts of Research Affiliates aren't generally very different from the forecast you'd get from a more complete model.

Old-school investors (ironically, including Jack Bogle) are more likely to overlook the effect of net buybacks than modern investors. When I did my MBA 20 years ago we were already being taught to account for buybacks in our DDM calculations even in introductory finance classes.
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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by lazyday » Thu Sep 12, 2019 7:05 am

AQR also includes buybacks where appropriate. https://www.aqr.com/Insights/Research/A ... et-Classes

Both AQR and Research Affiliates explain their methodology in detail. As I recall, RA discusses buybacks in the methodology paper linked by vineviz, and assumes that dilution will be at least as large as buybacks over time. Though it may have changed since the last time I read it.

For AQR, I'd start with the 2019 papers above, and for some areas you might find more detail in prior year papers including appendices. Though as I recall, they have changed methodology over time.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by SovereignInvestor » Thu Sep 12, 2019 7:13 am

vineviz wrote:
Thu Sep 12, 2019 6:40 am
packer16 wrote:
Wed Sep 11, 2019 2:52 pm
Do you know how they explicitly incorporate this into their forecasts & the magnitude of the changes from a raw valuation model would be. TIA.
Unfortunately, it all boils down to who "they" are. Every firm that publishes market forecasts has their own methodology, and you'd need to go through the details of each one to figure what additional adjustment for buybacks (if any) would need to be made.

BNY Mellon, for instance, already explicitly includes net buybacks in their valuation model. link

The Vanguard Capital Markets Model is a risk-based model (using both macroeconomic and financial market risk factors for each asset class and geography) and therefore doesn't require any adjustment for net buybacks or dilution. link

Research Affiliates, which is Rob Arnott's firm, on the other hand uses two different forecast models. They use both a valuation model (which would not be affected by buybacks) and a yield growth model (which uses only dividend yield, AFAIK, and would therefore be a target of the criticism that Straehl & Ibbotson were leveling). link Even there, though, they do apply a dilution correction factor when doing market-level forecasts but there is some question about who accurate it is. Straehl & Ibbotson specifically call it out as being theoretically questionable (because it basically just assumes a constant 2% dilution rate, without accounting for the variability in buyback rates) but note the final forecasts of Research Affiliates aren't generally very different from the forecast you'd get from a more complete model.

Old-school investors (ironically, including Jack Bogle) are more likely to overlook the effect of net buybacks than modern investors. When I did my MBA 20 years ago we were already being taught to account for buybacks in our DDM calculations even in introductory finance classes.
BNY uses 2.6% as total US yield for its assumptions. The buyback + dividend yield averaged over 5% since 2010.

Seems like they are way way too low there.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by Ping Pong » Thu Sep 12, 2019 7:18 am

Just use an earnings discount model.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by vineviz » Thu Sep 12, 2019 7:27 am

SovereignInvestor wrote:
Thu Sep 12, 2019 7:13 am
BNY uses 2.6% as total US yield for its assumptions. The buyback + dividend yield averaged over 5% since 2010.

Seems like they are way way too low there.
Possibly, though I tend to agree with them that the earnings yield over the past decade is not likely to prove sustainable. It's certainly been way above the long-term average, which is the basis for the BNY forecast.
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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by packer16 » Thu Sep 12, 2019 7:36 am

Thanks for the references. It appears that the buybacks in US are modeled but what appears to be missing is the dilution in EM & foreign markets. This appears to have a material influence on why EM markets are lagging DMs, according to Net Buybacks & the Seven Dwarfs (Jean-François L’Her, Tarek Masmoudi & Ram Karthik Krishnamoorthy, FAJ Sept 2018). Here is the conclusion of the study:

In short, the main finding of this study is that the cross-sectional relationship between stock market returns and net buybacks has been significantly
positive. Net buybacks have explained 80% of the cross-sectional dispersion of stock market returns of developed and developing markets since 1997, hence dwarfing the seven other building blocks considered in the decomposition of stock market returns: dividend yield, real per capita GDP, price-to-dividend variation, profit margins, payout ratios, relative dynamism of the market index versus the economy, and inflation/currency returns.

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Last edited by packer16 on Thu Sep 12, 2019 7:46 am, edited 1 time in total.
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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by Valuethinker » Thu Sep 12, 2019 7:41 am

vineviz wrote:
Thu Sep 12, 2019 7:27 am
SovereignInvestor wrote:
Thu Sep 12, 2019 7:13 am
BNY uses 2.6% as total US yield for its assumptions. The buyback + dividend yield averaged over 5% since 2010.

Seems like they are way way too low there.
Possibly, though I tend to agree with them that the earnings yield over the past decade is not likely to prove sustainable. It's certainly been way above the long-term average, which is the basis for the BNY forecast.
My impression, perhaps wrong, is that that profit growth has also been concentrated in a relatively small number of companies?

- the FAANGs + Microsoft. Apple made more money in one year than any company had ever, previously (I think in real terms, not just nominal)

- US banks, the recovery from the huge losses of 2008/9 (perhaps other financials as well)

In other words the investing world has felt like corporate America is experiencing one of those "paradigm shifts" in strategy-speak. Google, Amazon, Microsoft, Facebook experience increasing returns to scale, and that drives scale transformation. Rather what WalMart did to retail say 1980-2000 - not only did it grow its profits, it took all the profits away from other retailers and many suppliers.

(Peter Lynch described WalMart as one of his biggest mistakes. They did not have stores in the Northeast. And the one visit he did make to one was hurried - he missed what was going on. Missed a 10-bagger, maybe a 20-bagger, over that time period).

There was that McKinsey piece around 2000 which suggested that most of the growth in US productivity post 1990 could be accounted for by 1). improvements in the efficiency of computer manufacture (Dell, Cisco etc.) 2). online execution of finance (Charles Schwab; online banking was quite rudimentary in 2000) 3). WalMart and the revolution in business logistics it drove, the first company to put satellite trackers on its trucks, cross dock logistics etc).

I see analogies to the 1920s - telephones, electricity networks, radio. The industries which dominated the middle of the 20th century (ex Television, and RCA was a leader there) with huge network effects (the benefit to each user scales with the increase in the number of users - a la Facebook). Cars would have been another - the internal combustion engine and the network of auto garages & petrol (gas) stations. A few huge industry dominating competitors emerged - RCA, AT&T, Sam Insull's public utility structure (which collapsed in the Great Depression). There may have been something similar going on in department stores/ Sears catalogue - not sure about timing.

Of course Amazon & Netflix reinvest all that cash flow into new products & product lines, so the shareholder does not directly benefit on the EPS line. Whereas Microsoft avoided the "transforming" deal that is often the death of a highly profitable company, and has just continued to churn out profits with underlying cash flow even stronger, allowing buyback of shares.

Apple and its billion iphones at a superb margin for a commoditized product (the hardware that is) - say $1 trillion of sales there, not sure what profit margin.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by packer16 » Thu Sep 12, 2019 7:58 am

An interesting point about above average profits is there is some evidence out there that it may be sustainable if we enter a new area of innovation. Joe Davis at Vanguard thinks this may be the case. He tracks patent filings & the subsequent advances in technology/investment opportunities & thinks today may be similar to the early 1990s in terms this metric. He discusses this on one of Barry Ritholz's "Masters in Business" podcasts.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by Valuethinker » Thu Sep 12, 2019 9:30 am

packer16 wrote:
Thu Sep 12, 2019 7:58 am
An interesting point about above average profits is there is some evidence out there that it may be sustainable if we enter a new area of innovation. Joe Davis at Vanguard thinks this may be the case. He tracks patent filings & the subsequent advances in technology/investment opportunities & thinks today may be similar to the early 1990s in terms this metric. He discusses this on one of Barry Ritholz's "Masters in Business" podcasts.

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Interestingly what I had seen written is something of the opposite.

New technologies create better opportunities for consumers. They make the lives of end consumers better.

For example the lifecycle cost per lumen for a consumer of an LED is something like 1/10th that of an incandescent bulb (depends on your assumptions re retail electricity prices).

That incandescent bulb, in terms of average worker wages, cost something like 1/100th (or even 1/1000th) per lumen of what a tallow candle cost in the 1500s.

https://lucept.files.wordpress.com/2014 ... -light.pdf (I am alluding to this paper, an unpublished version of one of the most famous in economic history, without checking it).

But one cannot derive from that that the providers make exceptional profits. Electricity generation is a capital intensive business and the return on that capital is not, usually, that amazing.

What new technology tends to do is destroy existing profit pools. And may force early scrappage of old technology - the way gas-fired power stations (+ cheap natural gas from new drilling technology) have totally disrupted electricity generation, for example. Natural gas went from less than 10% of US electricity generation in the 1980s to over 40% now - almost all of that market share loss came at the expense of coal.

Fracking is, in effect, doing that to OPEC - putting something of a cap on how oil prices can go except for the inevitable geopolitical spikes. Yet at least some of the data I have seen suggests that fracking has created no real cash flow net of investing. Consumers of oil and gas are benefiting but not necessarily producers.

Exception is where there are natural monopolies - increasing returns to scale at all levels of output. Search engines. Possibly Amazon Web Services. Network effects in Facebook. Microsoft Office. Mobile phone franchises. Etc.

A small group of companies is taking a lot of profit out of the system.

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Re: Why Do Historic Share Dilution/Buybacks Not Factor into US & Foreign Expected Returns

Post by SovereignInvestor » Thu Sep 12, 2019 11:01 am

vineviz wrote:
Thu Sep 12, 2019 7:27 am
SovereignInvestor wrote:
Thu Sep 12, 2019 7:13 am
BNY uses 2.6% as total US yield for its assumptions. The buyback + dividend yield averaged over 5% since 2010.

Seems like they are way way too low there.
Possibly, though I tend to agree with them that the earnings yield over the past decade is not likely to prove sustainable. It's certainly been way above the long-term average, which is the basis for the BNY forecast.
How is the earnings yield too high and unsustainable?

Do you mean shareholder yield?

I think it will be lower of valuations rise.

S&P companies on average paid out less than 100% of operating profits since 2010..
Seems sustainable.

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