Billionaire and activist investor Carl Icahn usually makes news with his successful corporate proxy fights, which are more often than not very profitable for him and his investors. Last week, however, he made news by withdrawing from perhaps his most visible campaign in which he attempted to force Apple (AAPL) to boost its already hefty buyback program by $50 billion. Perhaps the fact that a week earlier Apple CEO Tim Cook confirmed that the company had repurchased some $14 billion in two weeks, bringing the total amount used to repurchase shares in the last 12 months to some $40 billion, had something to do with it. Or maybe it was the fact that Mr. Icahn made more than $400 million in paper profits by the time he gave up the “fight.” The bigger story, though, in our view, is what this says about the current state of affairs at public companies in the U.S. Have share buybacks really become a substitute for revenue and earnings growth? Will they be the only way the stock market can propel to higher highs? As is often the case, the answer to these questions is: it depends.
For more comprehensive and substantive answers, though, we decided to dig through the numbers of what most financial journalists consider a proxy for U.S. public corporations: the S&P 500 Index. And, of course, we also did our research on what we consider to be the best proxy for the growth of the most promising companies in the U.S.: the Barron’s 400. The results might not be that surprising to regular readers of our newsletter.
Among current Barron’s 400 companies, 370 have enough data for a three-year comparison (the others were not around three years ago). These companies, on an aggregate basis, saw their net income grow in the last three years by 56.3%. Revenue, on the other hand, grew by 28.8%. Not surprisingly, based on these results, B400 has gained 51% on a cumulative basis in the last three years. Over this same period of time, however, current B400 components have seen their diluted shares outstanding decline by only 3%. Clearly growth has driven the index’s gains.
The S&P 500, by way of comparison, has seen its aggregate net income grow in the last three years by 26% and its revenue increase by 15.6%. This has propelled a cumulative gain of 40% in the index also in the last three years. In the meantime, the aggregate diluted shares outstanding of all S&P 500 components have fallen by only 2.2%, less than B400. Keep in mind, however, that our analysis treats all companies in the S&P 500 equally even though this is a market cap weighted index. In contrast, when analysts and journalists report on corporate earnings and sales growth for the S&P 500, their numbers reflect the index’s weighting, in which the top 10 holdings account for almost 18% of the index. Our analysis focuses instead on the total dollars sold and earned by all companies in the index without distorting these numbers based on market capitalization. This allows for a side-by-side comparison between the two indexes.
| Barron’s 400 Index | S&P 500 Index | |
| Net Income Growth – 3Yrs. | 56.3% | 26.0% |
| Revenue Growth – 3 Yrs. | 28.8% | 15.6% |
| Change in Diluted Shares Outstanding | -3.0% | -2.2% |
| Companies that Decreased Shares | 178 (48.1%) | 293 (60.3%) |
| Companies that Decreased Shares by at least 10% | 62 (16.8%) | 111 (22.8%) |
| Companies that Increased Shares | 192 (39.7%) | 193 (39.7%) |
| Companies that Increased Shares by at least 10% | 56 (15.1%) | 59 (12.1%) |
Things get interesting, though, when we break down both indexes into the companies that are buying back shares and those that are actually issuing new shares. Here the difference between both indexes is quite significant. Among B400 components, 178 companies, or 48.1%, have decreased their share count in the last three years. 62 of them, or 16.8%, have done so by at least 10%. Over the same time period 192 companies, or 51.9%, have increased their share count with 56 of them, or 15.1% having done so by at least 10%. So, more B400 companies have diluted their shareholders in their last three years than those that have retired shares.
Among S&P 500 companies, 293, or 60.3% have shrank their share count in the last three years. This is more than 12 percentage points more than the proportion of B400 companies that have reduced their share count. 111 of these S&P companies have shrunk their share base by more than 10%. That’s 22.8% of all companies in the index. On the flip side, 193 companies, or 39.7% have actually increased their share count, with 59, or 12.1%, doing so by more than 10%. Such stark contrast between both indexes suggests a couple of points worth highlighting: S&P 500 companies are obviously much larger, on average, than B400 companies, thus making it harder for them to move the needle from a growth perspective (the median market cap for the S&P 500 is $67 billion while for B400 it is $4.3 billion). B400 companies are also younger companies than those in the S&P, at a stage in their corporate development where they need to issue new shares to attract the talent they need to grow; they also need to conserve much of the cash that larger, older companies use to fund buybacks in order to invest in their future growth and one day grow to be larger companies. It is this dynamic that B400 is so good at capturing. A closer look at the growth for both sets of companies helps paint a clearer picture.
When we isolated the S&P 500 components that have been retiring shares in the last three years from the rest, we found that this majority of companies (remember, they account for 60.3% of the index) had a much inferior growth in their net income than the overall index. In fact, their aggregate net income grew by 19% in the last three years compared to 26% for the index. The same happened to their growth in sales. Companies with a lower share count today saw their aggregate sales climb by 13.8%, compared to 15.6% for the whole index. Their diluted shares outstanding fell by 8.6% in the aggregate over this period.
On the other hand, when we look only at the S&P 500 companies that have diluted their shareholders in the last three years, we find that their aggregate net income growth is almost double that of the index itself, up 43.9% vs. 26%. Revenue growth for this group is also better than for the entire index, up 20.3% in three years compared to 15.6%. Unfortunately this group only accounts for 39.7% of the index on an equally-weighted basis.
While similar dynamics play out for B400 components, the numbers themselves are eye opening. Among companies that have reduced their share count in the last three years, net income growth was 43.9% vs. 56.3% for the index. Revenue growth is also lower, up 24.3% vs. 28.8%. These companies, however, account for less than half of the index.
The other half, or 51.9% to be precise, tells the best part of the story. Their net income growth in the last three years was almost twice as large as that of the index itself, with gains of 109.1% vs. 56.3%. Their sales growth was a remarkable 45.7% compared to 28.8% for B400 as a whole. All this growth occurred despite diluting their shareholders by 9.7% over this same period of time.
| Barron’s 400 Index | S&P 500 Index | |
| Companies Buying Back Shares | ||
| Net Income Growth – 3Yrs. | 43.9% | 19.0% |
| Revenue Growth – 3 Yrs. | 24.3% | 13.8% |
| Diluted Shares Outstanding | -7.5% | -8.6% |
| Companies Issuing New Shares | ||
| Net Income Growth – 3Yrs. | 109.1% | 51.0% |
| Revenue Growth – 3 Yrs. | 45.7% | 20.3% |
| Diluted Shares Outstanding | +9.7% | +11.5% |
We would like to end with a couple of conclusions. Share buybacks, usually hailed by investors as almost a guarantee of future share price gains, are anything but a panacea. They need to be put into the proper context and compared to a company’s alternative uses for their cash. In Apple’s case, $14 billion dollars spent following a decline of 8% in the price of the stock after a pretty good earnings report strikes us a prudent corporate management, especially when the stock is trading at less than 12 times forward earnings. Second, dilution of existing shareholders, almost usually frowned upon by corporate purists, should not only be put into the proper context as well but should, in fact, be encouraged at companies with strong growth and sound fundamentals. They will, more often than not, benefit shareholders in the long term. And that is what B400 is all about.
