S&P 500 companies have spent $1.1tn on share repurchase programmes over the past two years, as executives struggled to turn modest economic growth into higher earnings. Lacking opportunities to invest, or at least shareholder support to do so, companies have spent money buying their own stock, which provides a boost to the size of profits reported per share.
Fresh records for buybacks are likely to be set, with changes to the US tax regime expected to trigger a repatriation of profits that have been held offshore for years.
A string of companies, including Boeing and Honeywell, have announced close to $90bn worth of share buyback programmes since the reforms were agreed in December. Bank of America Merrill Lynch estimates that of $1.2tn parked overseas, perhaps half of the post-tax total, or around $450bn, could be devoted to share buybacks.
“Shareholders are going to be banging on doors saying we want some of that money,” says Howard Silverblatt, senior index analyst at S&P Dow Jones. No matter that stock markets have set record highs of late, the expectation that spare cash must be returned to its rightful owners is putting managers under pressure.
“They almost have to buy when the stock is high. Timing the market is not something most companies can do,” adds Mr Silverblatt. But the new flood of dollars raises an old question about whose interest the practice serves.
Companies justify buybacks in terms of discipline and confidence. But, almost nine years into a stock market boom, executives are planning to buy shares when long-term valuations have rarely been higher. The latest surge comes as many companies have already piled up cheap debt simply to fund payouts to shareholders.
Meanwhile, the proportion of sales spent on research and development at S&P
500 companies is still yet to recover to pre-2008 levels. William Lazonick, professor of economics at University of Massachusetts Lowell, is a critic of what he calls “profits without prosperity”. Blaming the financialisation of business, he sees in the mantra of shareholder returns the neglect of investment over short-term profits.
“The only benefit of share buybacks is to people who are in the business of selling shares: executives,” he says.
Do buybacks undermine the financial health of companies, juice bonuses and threaten the real economy? Lex examines the charge sheet.
Staff benefit more than shareholders
Companies are run on behalf of a diverse range of investors often with competing interests. Calls for buybacks can sometimes be seen as a response to a lack of trust from some investors that managers will spend the cash wisely.
“The positive view mostly comes from a period when many companies were sitting on too much cash, and investors intended [the buyback] as a way to impose discipline,” says Fabrizio Ferri, associate professor at the Columbia Business School.
Corporate raiders such as Carl Icahn, who rose to fame in the 1980s by breaking up flabby conglomerates for profit, evolved into activist investors preaching a mantra of shareholder returns.
Today, the announcement of a buyback can be a signal that shares are cheap, or a response to discontent with profits or strategy. Before General Electric announced a cut in its dividend last year, for only the second time since the depression, the manufacturing conglomerate was part way through a $50bn programme of repurchases announced while under pressure from the activist investor Nelson Peltz.
For many companies, particularly those in the technology sector, routine buybacks are a consequence of rising share prices. “The connection between stock compensation for employees and buybacks is very real,” says David Zion, founder of Zion Research. Staff sell stock awards, forcing companies to buy to keep the share count stable. Apple has admitted that a primary purpose of its buybacks is to neutralise the impact of stock compensation.
The company has spent $151bn on repurchasing stock in the past decade, about 17 per cent of its almost $900bn market valuation. The number of shares has dropped by about the same amount — 17 per cent. Yet when Apple started to buy in 2012, the shares could be bought for half today’s price. The difference has been handed to employees.
Opportunity for manipulation
Unlike a dividend paid at regular intervals, executives usually have authority to buy back stock at their own discretion. For most of the last century boards were reluctant to grant it because a company that dipped into the market to buy its own stock would arouse suspicion of market manipulation.
In 1982, however, the US Securities and Exchange Commission outlined a legal “safe harbour” for buybacks. Their popularity soared in the 1990s, as companies began rewarding executives with stock options. The value of such grants is tied to the share price, with dividend payments doing little or nothing for a chief executive’s remuneration.
In 1998 the value of buybacks by S&P 500 members topped that of dividends for the first time. The pattern has been repeated in 13 of the past 14 years.
Purchases can be used to shrink the number of shares in issue when earnings per share needs a boost, or to support the price when employees are exercising options to sell stock. Little disclosure about the precise timing of buybacks is required, and the area is not one where the SEC, which polices accounting issues, has typically taken action.
But the manipulation charge tends to fall flat because investors can see what is spent each quarter, and track movements in the number of shares in issue. They also tend to have an interest in a higher share price, and reward companies whose profits are predictable.
For instance, between 2005 and 2007 GE was one of the largest acquirers of its own stock, spending $32bn. When the financial crisis hit in 2008, the company was forced to raise $15bn from investors, leading to criticism that the repurchases were not the best use of capital. Yet shareholders had cheered the activity at the time.
Equilar, which benchmarks corporate compensation, says that just over half of US listed companies use a total shareholder return metric, which adds dividends to share price gains, when setting executive pay.
Only about a third of boards use EPS to determine pay awards. “Companies realise that buybacks have an effect on EPS,” says Dan Marcec of Equilar. “When a company buys back shares at the same time it is using EPS as a performance metric, it will almost always have a way of adjusting for that effect”.
Verdict Not guilty. Blame the investors, board and disclosure rules if some managers manipulate EPS.
Executives can be a bad judge of value
The only year in the past 14 when big US companies spent less on buybacks than dividends was 2009, when the S&P 500 index hit rock bottom. “The best time to do [a buyback] is in a recession, but that’s when everyone is scared stupid,” says Andrew Lapthorne, a quantitative strategist for Société Générale.
If a company has more cash than it needs, and nothing better to invest in, it should consider whether buying its own stock is a good investment. Yet the time when companies have plenty of spare cash tends to be when business is good and shares are overvalued.
Many companies bought back shares before money became tight. Commodity trader Glencore announced a $1bn buyback in 2014, but a year later it cancelled the dividend and raised equity as it scrambled to cut debt after commodity prices crashed.
But it is hard for executives to hold on to cash in anticipation of a distant downturn, or to argue that their shares are overpriced. Few companies are ever explicit about the thinking or calculation that determines when it makes sense to repurchase.
Warren Buffett’s Berkshire Hathaway is an exception. The conglomerate of insurers and industrial companies does not pay a dividend, and rarely repurchases shares. Mr Buffett has said he will buy them only when the stock is undervalued, defined as less than 1.2 times the stated book value of its assets, something that has not occurred in years.
Buybacks reduce real investment
Some companies have managed to spend more on buybacks in recent years than the shares are worth today.
Since 1995 IBM, the consulting and supercomputer group, has spent $162bn to repurchase more than half of its outstanding shares. What is left, for those who did not sell, is a company now valued at $154bn, suggesting the money was spent in the wrong place.
Any company will wonder what its valuation might have been, were different decisions taken. Prof Lazonick points to the example of Cisco Systems, the world’s largest networking company. In two decades it has spent $75bn repurchasing stock, more than three times the total for capital investment in property or equipment. A serial acquirer of other businesses, it has long struggled to grow sales.
Prof Lazonick suggests a dramatic alternative reality for the company, pointing to an employee-owned business that has taken much of the market for the infrastructure underpinning mobile phone networks. He says: “There’s the company that Cisco should have been, or could have been, and it’s the Chinese company, Huawei”.
Verdict The jury is out.
Three of the most dangerous words in the English language are “debt is cheap”. Low interest rates have encouraged corporate borrowing to buy back stock and boost earnings per share. “Traditionalists would say equity is expensive and not tax efficient. Debt is cheap and tax-deductible. The problem with that argument is it completely misunderstands credit risk,” says Mr Lapthorne.
The beauty of equity as a source of capital for business is that as it is perpetual, it does not need to be repaid. In a credit crunch or downturn, dividends can be cut to save cash, fresh equity sold.
Yet the popularity of buybacks has changed the cycle, for listed companies at least. Before the 2008 financial crisis, measures of indebtedness, or so-called leverage, fell. Overall debt levels were rising, but asset values were also much inflated. For non-financial companies in the S&P 1500, net debt as a proportion of assets dropped from 21 per cent in 2000, to below 9 per cent five years later. This time the metric has steadily risen along with the market, to exceed 19 per cent.
Last April the International Monetary Fund calculated that $7.8tn had been added to the liabilities of US companies since 2010. Median net debt of S&P 500 companies was close to a record high of 1.5 times earnings. Contemplating Federal Reserve plans to raise interest rates, the IMF last year warned that businesses representing a fifth of corporate assets could struggle to meet higher interest costs.
Verdict Guilty as hell.
Guilty on three out of five charges, executives who propose to spend money on expensive shares will be condemned to the enduring suspicion of shareholders. Early parole will be granted for good behaviour, including clear articulation of how a company approaches the decision to buy its own stock, and for investment in the real economy.
Additional reporting by Tom Braithwaite in San Francisco
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