There’s an ongoing argument in the financial community about the effect the current elevated level of stock buybacks is having on the financial system and economy in general.
As a result, Both Deutsche Bank and McKinsey have looked at buybacks during recent months and concluded that these concerns are unfounded.
Share buybacks: Truths, myths and technical bits
Over 400 companies in the S&P 500 repurchased stock last year, spending a total of $575bn in the process. That is about 3% of the index’s market cap and is up 14% from 2013, nearly matching the $600bn record set in 2007.
According to Deutsche Bank, corporate America isn’t scrimping on capex to pay for additional buybacks. US non-residential investment (a proxy for corporate capex) is running at 12.8% of output in nominal terms, or 13.3% in real terms, matching the 2007 peak and well above the highest levels of the 1980s and 1990s after adjusting for inflation. But that’s not all, companies have shifted their capex spending from investing in structures to investing in high-tech equipment, software and various kinds of intellectual property all of which have seen prices fall over the past 15 years. However, prices for structures are some three times higher than the personal consumption price index since 2000.
Home Depot is a great example of this change:
“Home Depot is a good example of a company that drastically shifted its capex strategy in response to market changes. Before the crisis, the company spent about 55-60 per cent of its operating cash flow on capex as new superstores were built. But with the growth of internet-related retail activity, Home Depot no longer needs more physical stores. The resulting shift in focus to its online capabilities has cut capex to about a fifth of operating cash flow. The company has used the freed-up cash to resume a large share buyback program. What if it had kept the cash instead? Would critics of buybacks be happy knowing the money might get ploughed into more and potentially redundant super stores? Or would they prefer management diversify within the big-box retail sector, perhaps by buying Sears; or how about turning that excess retail space into cloud computer server farms?” — Deutsche Bank on buybacks.
McKinsey has reached the same conclusion:
“…there’s little evidence that distributions to shareholders are what’s holding back the economy. In fact, on an absolute basis, US-based companies have increased their global capital investments by an inflation-adjusted average of 3.4 percent annually for the past 25 years —and their US investments by 2.7 percent. That exceeds the average 2.4 percent growth of the US GDP. Furthermore, replacement rates have remained similar. Capital spending was 1.7 times depreciation from 2012 to 2014, compared with 1.6 times from 1989 to 1999. The only apparent decline is in the level of capital expenditures relative to the cash flows that companies generate, which fell to 57 percent over the past three years, from about 75 percent in the 1990s.”
“That’s not surprising, given how much the makeup of the US economy has shifted toward intellectual property–based businesses. Medical-device, pharmaceutical, and technology companies increased their share of corporate profits to 32 percent in 2014, from 13 percent in 1989. Since a company’s rate of growth and returns on capital determine how much it needs to invest, these and other high-return enterprises can invest less capital and still achieve the same profit growth as companies with lower returns. Consider two companies growing at 5 percent a year. One earns a 20 percent return on capital, and the other earns 10 percent. The company earning a 20 percent return would need to invest only 25 percent of its profits each year to grow at 5 percent, while the company earning a 10 percent return would need to invest 50 percent of its profits. So a higher return on capital leads to higher cash flows available to disburse to share-holders at the same level of growth.”
“That is what’s happened among US businesses as their aggregate return on capital has increased. Intellectual property–based businesses now account for 32 percent of corporate profits but only 11 percent of capital expenditures—around 15 to 30 percent of their cash flows. At the same time, businesses with low returns on capital, including automobiles, chemicals, mining, oil and gas, paper, telecommunications, and utilities, have seen their share of corporate profits decline to 26 percent in 2014, from 52 percent in 1989 (Exhibit 2). While accounting for only 26 percent of profits, these capital-intensive industries account for 62 percent of capital expenditures—amounting to 50 to 100 percent or more of their cash flows.”
“Here’s another way to look at this: while capital spending has outpaced GDP growth by a small amount, investments in intellectual property—research and development—have increased much faster. In inflation-adjusted terms, investments in intellectual property have grown at more than double the rate of GDP growth, 5.4 percent a year versus 2.4 percent. In 2014, these investments amounted to $690 billion.”
A more concerning problem
While it can be argued that current level of buyback activity isn’t holding back economic growth, there’s plenty of evidence to support the conclusion that volume of cash devoted to buybacks tends to peak near the end of bull markets. This means most companies are undertaking buyback programmes at the worst possible times.
In a recent research paper, Goldman Sachs Group noted that buybacks peaked in 2007 with 34% of cash spent and hit a trough in 2009 at 13% of cash spent. In other words, companies bought the most of their stock near the 2007 stock-market high, and the least near the 2009 bear-market low.
The tendency for companies to undertake buybacks at the worst possible time could be more damaging than anything else. Aside from the fact that poorly timed buybacks are a momentous waste of shareholder funds, which could be held back for a rainy day, the transfer of wealth from shareholders to CEO’s is extremely concerning.
Indeed, according to Research Affiliates, via the Economist, last year US public corporations spent $696 billion buying back stock.
However, companies issued around $1.2 trillion of new stock via rights issues, stock options plans, etc…Research Affiliates reckons that the net dilution was around $454 billion and remarks that CEO’s are approving buybacks to offset the dilution from options.
“The net impact is a transfer to management of more of a company’s cash flow than is reported as compensation on the income statement.”
What’s even more concerning is the fact that these are being funded almost entirely with debt on a net basis. US companies issued a net $693 billion of debt during 2014. As the Economist concludes:
“Investors are ending up owning a smaller portion of a more highly-indebted company; more of the cashflows generated by such groups will be absorbed by banks and bondholders.”