Are Stock Buybacks a Necessary Evil?

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Corporate revenue growth has been in a funk ever since the end of the recession, forcing companies to find other ways to increase earnings per share, and there’s no more direct or popular way to do that than stock buybacks.

stock buybacksNaturally, the market loves stock buybacks. When a company takes shares out of circulation, the remaining ones become more valuable. Sure, a company can boost earnings through cost cuts like layoffs — the market loves those, too — but financial engineering in the form of stock buybacks is preferred.

Stock buybacks increase earnings per share and also calm restive shareholders … but there are consequences down the road that aren’t often talked about. Companies that lavish cash on shareholders aren’t investing it for future growth.

As S&P Global Markets Intelligence said in a new report:

“The continued takeaway is that more than 20% of companies are buying their EPS growth via buybacks. Reduced share count comes at a time when most companies are searching for earnings growth. Share count reduction now appears to be their favorite tool for enhancing earnings.”

Perhaps even more worrisome, S&P says that stock buybacks are now entrenched in the market. Investors expect them and they’ve become part of the market support system. In S&P’s view, corporate boards are “exchanging one addiction for another.” Meaning, stock buybacks are replacing low interest rates.

But it sure is hard to tell companies to stop — especially when earnings growth is so hard to come by organically, and dividend yields are so scrawny. The benefit to shareholders, at least in the short term, is too great.

Stock Buybacks Critical to Shareholder Returns

Just look at the sums disbursed in the first quarter. The No. 1 buyer of its own shares was Apple (AAPL), which repurchased almost $7 billion in stock. Heck, in the last five years, AAPL bought back nearly $80 billion in stock.

Rounding out the top five buyers in the first quarter, Pfizer (PFE), Microsoft (MSFT) and Verizon (VZ) repurchased anywhere from $5 billion to $6 billion of their own shares. Gilead Sciences (GILD) spent $3 billion on buybacks

Add up the rest of the S&P 500, and the boost to returns is impressive. Indeed, combined yields — the dividend yield plus the buyback yield — look very attractive in today’s environment.

In the first quarter alone, the consumer discretionary sector had a dividend yield of only 1.46%, but the buyback yield came to 3.15%. Taken together, the sector had a combined yield of 4.61% for the first quarter. That’s kind of a big deal in a quarter when the sector had a share-price gain of 4.4%.

The S&P 500 as a whole had a combined yield of 4.72% in the first quarter, thanks to the buyback yield of 2.7%. The market was essentially flat through the first three months of the year.

Buybacks can be nothing more than a wasteful form of financial engineering. But revenue growth was in bad shape even before the strong dollar starting chipping away at U.S. corporations’ top lines — and now it’s in outright decline. After dropping 1.7% in the first quarter, S&P 500 revenue is projected to shrink by 2% in the second quarter.

When revenue is stagnant or in decline — when demand simply is not there — companies have no incentive to spend cash on adding capacity and workers. Stock buybacks are hardly the most productive use of capital, but what else is management going to do?

Probably the only thing that could stop the stampede of stock buybacks would be accelerated revenue growth.

For now, however, stock buybacks are going to remain a significant contributor to shareholder returns.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/07/stock-buybacks/.

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