BACKING BUYBACKS

Edward Luce’s recent front page piece in the FT (The short-sighted US buyback boom) pretty well echoes the recent bashing against buybacks and villain executives and directors.

(…) At a time of soaring profitability, US companies have piled up huge amounts of cash, much of it parked offshore. Yet investing it in long-term growth is the last thing on their mind. According to Barclays, US companies have lavished more than $500bn in the past year on stock buybacks – a multiple of what most are spending on research and development and other capital investments. In the first six months of the year, buybacks surged to $338.3bn – the largest half-yearly volume since 2007. The rationale is simple. By reducing the volume of outstanding shares, chief executive officers increase earnings per share. That in turn lifts their pay, which is heavily tied to short-term stock performance. If you need an explanation for why the top 0.1 per cent is doing so well, start with equity-based compensation.

But the impact is much broader than that. According to William Lazonick, a scholar at the University of Massachusetts Lowell, seven of the top 10 largest share repurchasers spent more on buybacks and dividends than their entire net income between 2003 and 2012. In the case of Hewlett-Packard, which spent $73bn, it was almost double its profits. For ExxonMobil, which came top with $287bn in buybacks and dividends, it amounted to 83 per cent of net income. Others, such as Microsoft (125 per cent), Cisco (121 per cent) and Intel (109 per cent) were even more extravagant. In total, the top 449 companies in the S&P 500 spent $2.4tn – or more than half their profits – on buybacks in those years. They spent almost the same again in dividend payouts. Taken together, they came to 91 per cent of net income. (…)

In the past week, consumers have gone wild over the launch of the iPhone 6. It is US innovation at its best. Will Apple still be at the cutting edge a decade from now? Not if you judge by what it does with its cash. The company keeps tens of billions of dollars offshore to avoid paying US corporate taxes. Yet it borrows at home – including a record $17bn bond issue last year – to fund a massive share buyback spree (Apple spends more on equity repurchases than any other US company). The roots of the problem lie with poor governance regulations and a badly outdated tax system. Unless these are fixed, boardrooms will keep on draining their treasuries at the expense of other stakeholders. Greed will always be with us. Dumb laws are optional.

Let’s look at the facts.

The following chart plots the proxy for the S&P 500 Index share count since 1990:

Shares outstanding for the entire S&P500 Index are currently down 1.7% YoY. Ten companies (2% of the Index companies) dominate buybacks, accounting for 23% of the buyback value during the last 12 months. Traditional buyback to free cash flow relationships don’t matter for these ten companies as they all happen to have humongous cash reserves and pristine financial ratios. Their cash reserves earn nothing while the shares they buy back pay an annual dividend between 2.0% and 3.5%. Quite a positive carry if there is one!

Applying the weight of these 10 companies on the whole S&P Index and pretend that S&P 500 companies, overall, foolishly overspend their operating cash flows on buybacks requires total blindness, naivety, ignorance or intentional deception.

Here’s what Luce and many others fail to mention:

• A lot of the buybacks are meant to offset option grants.
• The ten major buybackers are also among the largest option granters.
• Most of these companies have humongous cash piles and the decision to buyback shares has little to do with current earnings or cash flows.

As to the argument that corporate executives are short-term greedy and are underinvesting for the longer term, the statistical aging of the capital stock is a trend that has actually been on for almost 50 years. From my lens, the U.S. does not appear to be at the back of the class on innovation and productivity (charts from Credit Suisse).

And, by the way, long-term growth is not the last thing on their mind as Luce asserts. In fact capex orders have been rising swiftly in 2014 (+16.6% annualized since February) and are now exceeding the last 2 cyclical peaks.

This is in spite of the still pretty low capacity utilization levels which, although near its pre-recession level, it is still well below the 83-85% threshold that may be dangerous for growth and/or inflation.

In all, corporate executives, as a group, do not appear to be shortchanging their stakeholders. Quite the opposite in fact since capacity utilization remains historically low.

Finally, the fact that large buyback companies have outperformed the overall market over the past 5 years is often used as exhibit to prove that managements are selfishly using buybacks to boost earnings per share and share prices. It may also be that these companies are outperforming in the first place because their corporate performances and financial ratios are superior, allowing directors to authorize large buybacks.