Investors appear to be getting wise to the buyback illusion, looking not just at shares being extinguished but at the greater number being created.

By any measure, the buyback binge pursued by U.S. companies has been huge, with S&P 500 companies buying back $553.5 billion in the year to June, up 3.8 percent from the year before. Overall, almost $700 billion was bought back in 2014 by U.S.-held companies, according to Research Affiliates data.

Just looking at the S&P 500, the buybacks equate to 2.9 percent of the index’s market capitalization.

Yet while the combination of buybacks and dividends is often referred to as “total shareholder return” that’s actually a misnomer, just as it would be if you called your purchase of an asset with borrowed money an increase in wealth.

Research Affiliates did a detailed study comparing the amount of stock U.S. companies issued during the same period they were also rebuying shares. This task is not made easy by companies, and requires not just a close read of cashflows but also comparisons derived from stock price movements and market capitalization data.

The result: those companies which bought back almost $700 billion in 2014 issued $1.2 trillion worth of stock and took on just about $700 billion of debt while doing so.

The truth: while a goodly amount of the stock issuance goes to mergers and acquisitions, much also goes to fund shares issued to pay insiders.

“When management redeems stock options, new shares are issued to them, diluting other shareholders. A buyback is then announced that roughly matches the size of the option redemption. This facilitates management’s resale of the new stock they were issued in the option redemption. Buyback? Not really! Management compensation? Yes,” write Chris Brightman, Vitali Kalesnik and Mark Clements of Research Affiliates, an asset allocation and smart beta product firm.

“Because the stock options a company issues its management dilute the value of its stockholders’ shares, companies often repurchase their stock to offset this dilutive effect. The net impact is a transfer to management of more of a company’s cash flow than is reported as compensation on the income statement. Irrespective of the intent of the company to reduce the dilutive impact of its options-based stock issuance with buybacks, the reality is that the dilution is not always totally offset.”

Getting Wise

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