by James Mack | December 28, 2011 8:15 am
Recently, Standard & Poor’s announced that stock buybacks by S&P 500 companies increased 8.4% in the third quarter from a quarter ago to $118 billion. That’s an astounding 49% jump from the same period last year and the ninth consecutive quarter of growth in repurchases.
So why are companies buying back their shares at a record pace? Well, there are a few different camps of thought on this:
Although the primary goal of every publicly traded company should be to maximize shareholder value, I think we all know that happens only in a vacuum.
We can debate whether current executive pay levels and bonus structures encourage or become detrimental to this objective. But one thing we do know is that many factors go into management decisions about what to do with excess cash that sits on the balance sheet.
Remember, company share repurchase programs reduce the number of outstanding shares, which means each existing share you own now represents a larger percentage of equity in the company. That fits the very definition of increasing shareholder value — but not all firms believe it maximizes that value, and thus is not necessarily the best use of cash.
For instance, Apple (NASDAQ:AAPL[1]) long has been notorious for simply sitting on mounds of cash — currently almost $26 billion of it. However, few investors would accuse Apple of not maximizing shareholder value during the past decade — after all, a 3,700% return tends to outweigh a little extra cash lying around.
Whether you agree, Apple always has been one to march to the beat of a different drummer. Laurie Hodrick, a economics professor at Columbia University, said this summer that one of the reasons U.S. companies were amassing so much cash was it provided them with financial flexibility in times of heightened economic uncertainty.
An optimist might infer that a willingness by firms to start putting that cash to work points to an improving economy in their eyes.
Sentiment surveys are nice water cooler fodder, but money talks, so moving cash off the balance sheet could be one of the most telling statements of what America’s CEOs think of the near-term outlook for the economy.
I think the primary reason we’ve seen so much share buyback activity is because firms believe their shares are severely undervalued. A company buying back its shares is investing in itself the same way any investor would. Buy low and sell high, right?
If they can buy shares at what feels like depressed values, then perhaps reissue those shares at a later date when the value is at a more appropriate level, then management is accomplishing the same goal we set out to. Of course, management must think the internal rate of return it can achieve on these share buybacks must exceed the returns it can get on other investment options — otherwise it becomes, for lack of a better term, financially irresponsible.
Of course, now we’re back in the vacuum.
But there’s no question that the public perception of a company that’s gobbling up its own shares is positive. It demonstrates confidence in the business — and encourages investors to think in kind.
I know what you’re thinking: If these firms are so confident in their businesses, then why aren’t they using this extra cash to build new factories, expand production, increase R&D budgets and the like?
The simple answer is an improving economy doesn’t mean it’s a good economy. A lot of the recent economic data certainly points to an economy attempting to find its footing, but it’s still by no means thriving. The Federal Reserve is forecasting GDP to grow by 2% to 2.5% in 2012; hardly a robust figure given average annual real GDP growth for the last century is 3.2%.
Also, I wouldn’t be surprised if that estimate gets revised down yet again, especially after the most recent quarterly figure was reduced from 2% down to 1.8% growth.
The trend of increasing share buybacks is in contrast to what’s happening in the dividend world. Only about 70 S&P 500 firms increased dividend payouts by more than 1% this year, and dividends per share actually fell from the second quarter to the third quarter of 2011.
Increasing dividend payouts certainly isn’t a one-way street, but it can be very difficult for firms to explain why they need to decrease dividends from existing levels. Which is why most firms are reluctant to use that extra cash on increasing its dividends — because once you head down that road, it’s never a good sign when you reverse course.
Buying back company shares is nothing like increasing dividends, adding production capacity or going on a hiring splurge — one is like making a right turn on your bicycle, and the others are like turning a cruise ship around.
Share buybacks are an easy way to put cash to work in a cloudy economic environment, and they don’t commit the firm to any capital or business strategy outside of the immediate cash outlay.
Sure, the economic signs are coming into focus, but they aren’t yet clearly visible. So until they are, I expect firms to continue favoring share buybacks to get rid of that excess cash.
As of this writing, James Mack did not hold a position in any of the aforementioned securities.
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