There was no sign of Carl Icahn’s trademark aggression in the letter he sent last week to Tim Cook, Apple’s chief executive. The one-time corporate raider began by applauding Apple’s recent product launches and calling Mr Cook the “ideal” CEO for the world’s most valuable company.
He then politely requested that Mr Cook ask Apple’s board to use more of its $133bn cash pile – together with money raised in the debt market – to buy back more of its shares. “We thank you for being receptive to us the last time we requested an increase in share repurchases, and we thank you in advance now” for pushing the idea again to the Apple board, he wrote.
While the 14-page letter lacked the antagonism he is known for, the billionaire investor was nonetheless placing himself at the centre of a fight: share buybacks have become one of the most contentious issues in corporate America. Mr Icahn and other “activist” investors argue that buybacks help successful companies such as Apple reach their true value. But to others, including Larry Fink, chief executive of BlackRock, they sap investment that could pay for jobs or research on new products in favour of short-term gain – ultimately hurting the economic recovery.
“Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks,” Mr Fink wrote in an open letter to chief executives this year. “We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons . . . it can jeopardise a company’s ability to generate sustainable long-term returns.”
Share buybacks are not new, but US companies have been gorging themselves on their own stocks in recent years – in part spurred on by activists such as Mr Icahn. But they are also a broader reflection of how the Federal Reserve’s aggressive policy of lowering interest rates has benefited financial assets – notably stocks, bonds and house prices – even as the recovery in the broader US economy has been halting.
The contrast between record share prices – the S&P 500 has nearly tripled since its March 2009 nadir – and the sluggish rebound remains a striking aspect of the central bank’s quantitative easing era, which draws to a close this month.
The longevity of QE and suppression of interest rates has created fertile conditions for the buyback boom. In the 12-month period to the end of June, S&P 500 companies have returned a record amount of cash to shareholders, consisting of $533bn in buybacks and paying out $332.9bn in dividends, according to S&P Dow Jones Indices. Since the start of 2011, buybacks have exceeded $1.6tn.
“When QE was launched, it was not envisaged lasting for five years,” says Edward Marrinan, head of credit strategy at RBS Securities. “It was seen as providing a short kick-start for the economy and not becoming a protracted policy that has changed the incentives for markets and companies.”
The post-financial crisis performance of the economy, dubbed by some as a “secular stagnation” during the QE era, has animated critics of buybacks. Rather than returning excess cash to shareholders, they say companies should invest in their businesses and recruit more workers at higher wages to sow the seeds for sustained long-term growth of the economy.
William Lazonick, professor of economics at University of Massachusetts Lowell, says buybacks manipulate share prices. While that can boost prices in the short term, their long-term consequences include undermining income equality, job stability and overall economic growth. “When you have an economy dominated by large-scale corporations, their decisions about the allocation of capital drives the economy,” he says. “Executives are judged on the performance of the company’s stock price and that is something they can control and manipulate.”
Apple epitomises the US companies selling cheap debt and then ploughing the proceeds back into enormous purchases of their own stock to pay chunky dividends to shareholders. Over the past 18 months, Apple has sold two blockbuster offerings of bonds to the tune of $29bn, which has helped fund $50bn of buybacks. It lags behind only ExxonMobil and IBM in terms of such largesse since the start of 2009.
Mr Fink says he feels strongly that activism such as Mr Icahn’s is “creating a chilling response” among chief executives, spurring them to eschew spending on capital expenditures in favour of share buybacks.
“I am not here to suggest that there are not examples where the activists were entirely right but when you have one activist tell Tim Cook to raise $150bn in bonds to buy back shares – I don’t agree with that type of behaviour,” he said in an interview.
Companies reducing their amount of outstanding shares and boosting earnings have provided a tail wind for the S&P 500’s bull run during the QE era. Barclays estimates that buybacks are adding more than $2 a share to S&P 500 earnings at the index level.
Buybacks are executed secretly since market knowledge of their size and actual timing would push prices higher and cost the company more. But the constant source of demand for shares via buybacks has certainly been rewarding for company insiders and equity investors.
Vadim Zlotnikov, chief market strategist at AllianceBernstein, estimates the top 100 S&P companies undertaking buybacks and issuing dividends – with share repurchases going beyond just settling expiring options – have outperformed the rest of the S&P by 4 per cent this year, and 8 per cent for all of 2013. “These are huge numbers,” he says.
Digging deeper into the numbers reveals a gulf between buybacks and cash spent on capital projects. Barclays estimates that the portion of cash flow allocated to repurchases for S&P 500 companies has increased to more than 30 per cent, nearly twice what it was in 2002, while the portion allocated to capital expenditures is down to 40 per cent from more than 50 per cent in the early 2000s.
Critics say devoting large amounts of cash to buybacks can also signal that a management team has run out of ideas for sources of long-term growth. A common example is how RIM splurged on buybacks when the BlackBerry dominated the mobile handset market, while underestimating the challenge being mounted by Apple and Samsung.
Thanks to cost-cutting and low interest rates, companies have generated record profits in recent years. But the missing component has been solid revenue growth because of a sluggish economy. As a result many companies have decided that the best option for deploying their cash flow is in acquisitions and buybacks.
Mr Zlotnikov says buybacks will continue until companies regain pricing power – a sign of a robust economy. “There are a lot of projects and investments that look less attractive when pricing power is under pressure.”
The most pressing question is whether US equities can continue rising as the Fed ends QE. Companies will face a higher cost of buying back their stock while having not yet really committed capital for long-term expansion.
Jonathan Glionna, head of US equity strategy research at Barclays, says the market has entered a period of lower returns as “share repurchases prove to be already priced in and a return of faster revenue growth becomes a prerequisite for another re-rating higher”.
With the central bank ending QE and poised to start normalising interest rate policy in 2015, the buyback boom has shown signs of easing, potentially removing a vital pillar of support for the equity bull run. In the three months ending in June, the pace of buybacks dipped to $116.17bn, the lowest quarterly figure since early 2013, though there are signs they picked up in the third quarter.
“Companies issuing at low yields into this buying frenzy are doing what they always like doing with debt in the final throes of an economic cycle: they issue cheap debt to buy expensive equity,” says Albert Edwards, strategist at Société Générale. “This pro-cyclical process always ends in tears and is regarded in retrospect as typical end-of-cycle madness.”
Share buybacks peaked during the third quarter of 2007, just before the financial crisis began. Companies that had splurged on share buybacks found themselves scrambling to save cash.
The rise in US share prices – thanks in part to QE – requires vindication in the form of a stronger economy, marked by rising wages that can propel consumer spending and company revenues. However, that requires a change in the mindset of companies whose managers have focused on their stock price rather than long-term growth, many argue.
“Wall Street loves buybacks as there is a large buyer supporting the market,” says Prof Lazonick, who believes the focus on cost cutting and buybacks has hurt average workers and exacerbated income equality. “A prosperous economy comes when people have stability in terms of being employed.”
Additional reporting by Tom Braithwaite
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