S&P company cash spending was roughly flat in 2023 even as EPS contracted about -3% y/y. Dividends were up 4%, but buyback spending was down about -15%, with most of the weakness coming from the first half. Buyback spending tends to be correlated to earnings growth trends, so some weakness last year was expected. Since 2H23, S&P EPS growth has turned positive, economic tail risks have eased, and buyback activity started to accelerate.
S&P EPS is expected to expand 9-10% in 2024, and buyback spending relative to net income is well below its post-GFC median. That backdrop makes a further acceleration of buyback spending more likely and is a support for fair value. Applying Professor Damodaran’s discounted cash return approach, and assuming an S&P ERP of 4.5%, puts fair value at 5170. Unless the ERP moves lower, there is limited upside to the large cap space today. When thinking about potential upside, market internals (style rotation, HERE) and moving down the cap scale offer more opportunities.
Large caps continue to lead cash returns, driven by MASSIVE spending by mega caps. What is interesting is that the cash return yield of small cap names is slightly higher than the S&P 500 ex the top 100 stocks. And the yield on small caps is about 80% higher than normal, while the yields on the top 100 and net 400 are LOWER than normal. The bottom line is that the small caps are trading at a discount to their cash return while larger cap names are at a premium.
We also look at the sector breakdown of yields. Mega caps cash return yield is broad with yields >4% across more than half of sectors. Within the small cap universe, Technology has a higher yield than larger caps. Industrials, Financials, and REITs also have better yields than non-mega S&P names.
Cash Return Rebounding: 2023 cash spending by S&P companies was roughly flat relative to 2022 despite macro headwinds and the -3% y/y contraction in EPS. Most categories were steady while R&D spending jumped 12%, driven by Health Care and Discretionary. M&A also perked up, expanding 10% y/y and 100% h/h. All the above is consistent with the easing of macro headwinds and the general improvement in earnings sentiment readings across the index.
Focusing on buybacks, spending in the first half of 2023 fell -25% y/y as earnings contracted and macro uncertainty peaked. In the second half, spending rebounded and ended flat relative to 2022. Buyback spending tends to be correlated to earnings growth trends, so some weakness last year was expected. S&P EPS is expected to expand 9-10% in 2024, setting the stage for a rebound in buybacks.
Buyback spending is more volatile than dividends but remains a larger source of cash return, a shift that really took hold post the GFC. Dividends were up modestly last year (+3%) but buybacks were down more than 15%. In 2H, as net income and cash flow improved in late 2023, cash return (dividends + buybacks) relative to S&P TTM net income and cash flow slipped lower even as buybacks picked up. Upward surprises on revenue, margins, and EPS + easing of economic tail risks suggest buybacks will continue to move higher throughout 2024.
Some of the Highest Yields are in Small Caps: Currently, the S&P cash return yield is at 3.4% driven by massive returns by the largest stocks. The next 400 (S&P 500 ex top 100 stocks) names have a combined yield of 3.1%, slightly below the cash return yields of the small cap index. And the yield on small caps is about 80% higher than normal, while the yields on the top 100 and net 400 are LOWER than normal. The bottom line is that the small caps are trading at a discount to their yield while larger cap names are at a premium.
Mega cap names cash return yield is broad with the yields within more than half of sectors >4%. Within the small cap universe, Technology has a higher yield than larger cap names. Industrials, Financials, and REITs also have better yields than non-mega S&P names.
Cash return is one part of fair value. The risk premium on equities is another and larger one. Applying Professor Damodaran’s equity risk premium calculation methodology (HERE), which measures current index value as a discounted future cash return, the current S&P ERP is around 4.5%. Most sector level ERP are near the index range, while Energy has the highest ERP at 7.5%. REITs and Technology have the lowest ERP levels. There isn’t a consistent relationship between ERP and return yields. In general, rising cash return yields should encourage lower ERP though.
Combining the two points above, the fair value for the S&P is currently around 5170, which is less than 2% higher than yesterday’s close price. Unless the ERP moves lower, there is limited upside to the large cap space today. When thinking about potential upside, market internals (style rotation, HERE) and moving down the cap scale offer more opportunities.
