The Buyback Tax Could Boost S&P 500 Heading Into the Fall

The Senate passed the Inflation Reduction Act on Aug. 7, and The House of Representatives will do their thing on Friday. Assuming it passes in the lower house, President Biden will sign the legislation into law after that. 

However, the 1% tax on share repurchases won’t take effect until Jan. 1, 2023, which suggests the S&P 500 is about to get a boost from accelerated buybacks in the final four months of the year. 

An argument can be made that buying an S&P 500 ETF before the onslaught begins is a better way to play the changes in capital allocation made by companies in both 2022 and 2023. 

Here’s why. 

A Rising Tide Lifts All Boats

According to Yardeni Research, over the past four quarters through the end of June, $984.6 billion in share repurchases were completed for S&P 500 stocks, to go along with $541.4 billion in dividends, bringing the total shareholder haul in 2021 to $1.51 trillion. 

At the beginning of 2022, Goldman Sachs estimated that buybacks would exceed $1 trillion, 12% higher than in 2021. S&P Dow Jones Indices data indicates 2021 buybacks set a record with $881.7 billion, up 69.6% from 2020, a 9.3% from the previous record in 2018 of $806.4 billion. 

Investors love share repurchases for two reasons: First, they reduce share counts, which increases earnings per share, and EPS drives share prices. Secondly, it allows companies to return capital to shareholders while enabling them to defer taxes until they sell their shares for a capital gain. 

At the end of 2021, S&P Dow Jones Indices predicted that buybacks in the first quarter of 2022 would continue at higher than normal levels. In Q1 2022, share repurchases increased 4.0% over Q1 2021, to a record $281.0 billion. Three hundred and seventy-four of the index’s components bought back at least $5 million in stock in the first quarter. Buybacks in Q2 2022 are expected to be higher than in Q1 2021. 

With the 1% tax ready to take effect, it’s easy to see why many on Wall Street expect an acceleration in share repurchases in the final five months of the year. 

“ The number one thing that stands out is that you're going to see an acceleration of buybacks before the end of this year,” Reuters reported Thomas Hayes, chairman and managing member of New York-based Great Hill Capital, said about the tax. “Companies would rather not pay that tax ... They have this window, and you can be assured they're going to take advantage of it.”

So, if 374 companies bought back more than $5 million in stock in the first quarter without any hint of a tax, it stands to reason that the number of index components buying back stock in the second half of 2022 will rise, as will the amount repurchased per company. 

Why Not Just Buy Apple and the Other Big Buyers?

S&P Dow Jones Indices’ data from Q1 2022 showed that the top 20 companies buying back stock accounted for 42.1% of the total share repurchases in the quarter. While that’s high, it’s nowhere near the 87.2% in Q2020. It’s also less than the pre-COVID historical average of 44.5%.

In Q1 2022, Apple (AAPL) bought back the most stock, repurchasing $23.0 billion, almost $10 billion higher than Alphabet (GOOGL), the second-highest company in the S&P 500. The top 20 companies bought back $118.2 billion during the quarter. Technology was the most significant stock buyer at $71.6 billion, or 25% of the total. 

It would be interesting to see whether an ETF could survive that invests in the top 20 S&P 500 buyers of stock, weighted by the dollar amount of buybacks made in the trailing four quarters. But that’s a subject for another day. 

One alternative to betting on all 505 stocks tracked by the S&P 500 would be to buy the Invesco S&P 500 Top 50 ETF (XLG). It follows the performance of the S&P 500 Top 50 Index, made up of 50 of the index’s largest companies. Apple is the ETF’s largest holding at 13.43%. The ETF’s top 10 holdings are also the top 20 buyers of stock.

Down the road, owning XLG over something such as the SPDR S&P 500 ETF Trust (SPY) might realize a more significant benefit from accelerated share purchases in the second half of 2022. 

In 2021, Apple repurchased $85.5 billion of its stock. If it buys back the same amount in 2023, it will cost the company $855 million in tax. Based on 16.07 billion shares outstanding, that would be a 5-cent hit to earnings. Apple’s expected to make $6.48 a share in 2023, so the impact of its buybacks would be negligible. 

For this reason, it makes sense to bet on XLG or SPY rather than on companies in the top 20, including Apple.  

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