December is typically a significant month for stock buybacks in the U.S., and this year is poised to break records, with companies expected to allocate more funds for share repurchase by the end of the month than ever beforeWhile this trend may seem like a cause for celebration in some circles, it has also raised a spectrum of concerns ranging from market manipulation to executive compensation strategiesIn the shadow of anticipated modest gains in U.Sequity markets over the next several years, investors may have to reassess their stance on buybacks, seeing them increasingly as a necessary component of total returns.

The narrative around stock buybacks is evolvingThey have become a pivotal element in driving overall stock returns, despite the recent underwhelming performance reflected in buyback yieldsData shows that S&P 500 companies spent approximately $790 billion on stock buybacks last year, a significant jump from the $170 billion recorded in the year 2000. Goldman Sachs had estimated as recently as March that 2023's buybacks would just shy of $1 trillion, with expectations to surpass that threshold by 2025. Interestingly, the S&P 500's aggregate valuation today is considerably higher than in 2000, although the proportion of buybacks to market capitalization is only marginally above historical levels.

To provide some perspective, in 2007, the buyback yield of the S&P 500 peaked at 4.7% but has been on a persistent decline, dropping to 2% last year

This might not seem particularly impressive, particularly against the backdrop of a total return rate of 26% during that same year, yet the historical record casts buybacks in a more favorable light when assessed over the long haul.

When considering the long-term performance of equities, returns stem predominantly from two key streams: capital distributions—traditionally manifested as dividends—and profit growthSince 1871, the annual total return rate of the S&P 500 has averaged about 9.3%, comprised of 4.6% from dividends, 4.1% from earnings growth, and a mere 0.6% attributed to valuation changesAlthough valuation shifts can substantially impact total returns over shorter durations, in the grand scheme, they tend to represent little more than noise.

Over recent decades, the yield from dividends has dropped significantly, averaging just 1.9% since the year 2000. However, buybacks have considerably compensated for this decline

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Between 2000 and today, companies have increased average dividends by 2.7%, effectively raising total average shareholder returns—comprising both dividends and buybacks—to 4.6%. Thus, despite altered methodologies in distributing profits to shareholders, average returns have remained relatively stable.

The shift from dividends to buybacks was not coincidentalInitially, regulators were wary of buybacks, concerned that companies might misuse them to manipulate share pricesThe turning point came in 1982 when the SEC sanctioned stock buybacks, representing a significant policy shiftThis development was beneficial since buybacks serve a purpose at least as meaningful as dividends, if not moreIn instances where companies lack compelling investment opportunities, they can strategically allocate profits instead of adhering to a rigid distribution scheduleAdditionally, shareholders typically face lower tax rates on buybacks compared to dividends.

Since the year 2000, save for three exceptional years, the contribution of buybacks to shareholder returns has consistently surpassed that of dividends

A significant case was the year 2009, during which companies missed the opportunity to repurchase shares at lower prices amidst the fallout of the financial crisisIn both dollar and yield terms, the buyback activity of that year was just a fraction of the peak seen in 2007, largely due to the turmoil in the financial system, leaving many companies cash-strappedDespite the exuberance of prior years, such hesitance to capitalize on market downturns may explain why post-crisis, companies have generally been content to allow buyback yields to dwindle as U.Sstock market valuations continue to rise.

As the S&P 500 index surged, buyback yields often went unnoticed, as has been the trend in recent yearsHowever, an analysis of both historical and expected long-term stock returns reveals that buyback yields are not insignificantFor instance, the S&P 500 index has recorded an annual return of merely 8% from the year 2000 to November of this year

A number of leading fund managers have forecast modest growth for the market over the next decade, estimating returns in the range of 3% to 6% per yearEven if markets achieve near 9% in long-term annual returns, buyback yields will undoubtedly remain a vital component of those returns.

Critiques of buybacks often lack convincing meritA recurring critique is that buybacks divert funds away from investments that could potentially enhance company valueHowever, the outcomes of increased investment are not guaranteed to be positive; they can just as likely yield adverse resultsResearch compiled by Ken French from the Tuck School of Business indicates that between 1963 and October, companies in the United States that engaged in low levels of investment outperformed their high-investment counterparts by approximately 3 percentage points annually, with low-investment firms outperforming in 83% of rolling ten-year periods