share buybacks

Pat S., an old Irish friend, writes:

Denis,
Looking at Dr Ed Yardeni’s website on historic earnings, I noticed that economic depreciation on replacement cost of fixed assets has turned sharply lower than depreciation reported by corporations for taxes in recent years. This isn’t due to 1970s style inflation, so it must be due to under investment. The seed corn is being eaten by share buybacks! That means a reduced quality of s&p eps.

There is a lot of stuff in this note but, being no economist, I will cut to the chase:

• The accounting for capex and depreciation in the national accounts does not hit a strong side of mine. I suspect, however, that trends towards outsourcing and the use of foreign subsidiaries for tax purposes blur long term relationships between capital investments, depreciation accounting and tax accounting.
• Gross capex in the U.S. grew very rapidly between 1992 and 2005, seemingly too quickly (and financially poorly) judging from low capacity utilization rates from 1998 to 2012.

• Corporations are back to a capex trend more similar to that of the early 1980s. Utilization rates may be back to 2005 levels, they nevertheless remain at the low end of their long-term range. CFOs are thus little inclined to boost capex even now, five years into the recovery and with interest rates at such low levels.
• The “under-investment” thesis does not strike me as solid.
• Meanwhile, cash is mounting and many corporations buy back their shares rather than boost unnecessary capex.
• Share buybacks may or may not be a financially smart move. We must be careful when analysing aggregate buyback data. There is a lot of excess cash but, upon closer examination, most of it rests in but a few companies. So with buybacks these days.
• In effect, Apple and IBM accounted for 9% of buybacks in Q4’13. The 5 largest buybacks represented 18.3% of all buybacks in Q4, the 10 largest: 27.3%. The ratios are very similar for all of 2013.
• Apple was the most active re-purchaser in 2013, buying back 5% of its outstanding shares. I challenge people to dispute the wisdom of Apple’s repurchase considering that its stock traded between 9 and 14x trailing EPS (cum a huge excess cash position) and between 3 and 4 times BV when its ROE is 30%+. Pfizer, the second most active re-purchaser in 2013, bought back 11.2% of its shares at about 2.5x BV when its ROE is 19%. When cash yields less than 1%, buybacks are hard to pass with such metrics.
• In fact, the math says that these 2 companies should witness an acceleration in their growth rate post these buybacks. Cash earning 1% dilutes growth and if you can reinvest it in an asset earning 8-10%, growth is enhanced.
• Share repurchases are only one factor determining the change in share count of a company. Most buybacks also seek to offset dilution from convertible securities or stock options, or the issuance of stock for acquisitions.
• Data from S&P shows that buybacks, in aggregate, have only reduced total shares outstanding by 1.2% over the last 4 years. Shares o/s declined 0.5% Y/Y in Q3’13, 0.12% in Q4’13 and rose 0.12% in Q1’14 (Charts below from Factset).

• There is no evidence that U.S. corporations are sacrificing capex for buybacks.