Despite the market’s uneven performance so far this year, corporations continue to aggressively repurchase stock. According to preliminary data from S&P Dow Jones Indexes, in 2014 U.S. multinationals spent $553 billion on buybacks and another $350 billion on dividends. This means companies are essentially favoring returning cash to shareholders over investing in research and development and capital investment. The uncertain economic environment has likely contributed to management’s preference to return cash to shareholders instead of investing more in future business growth.
Share buybacks is a topic we have discussed several times in the past (“Thoughts on Share Repurchase Activity Levels,” “Dividends vs. Stock Repurchase,” “Financial Engineering and Share Repurchases,” and “Greed in the Executive Suite“). While lower oil prices and a stronger U.S. dollar have resulted in more modest forecasts of earnings growth, the trend has continued this year. In February, chief executive officers announced $104.3 billion in planned repurchases – the highest level since TrimTabs Investment Research began tracking the data in 1995. It is also nearly twice the $55 billion bought a year earlier. Activity levels are supported by the low interest rate environment, as companies are able to borrow at very low rates and then use the proceeds to repurchase shares.
The current consensus among Wall Street analysts is that earnings growth for companies in the S&P 500 Index will be down on a year-over-year basis. However, strong buyback activity could help the index deliver positive earnings growth from a per share perspective. By lowering the number of shares outstanding, companies can artificially boost their earnings per share (EPS). For example, if a company earned $1,000 and had 1,000 shares outstanding last year, it would have EPS of $1.00 ($1,000/1,000). If it earns $995 over the same period this year and buys back 10 shares, its EPS would be $1.01 ($995/990).
From an overall market perspective, Orrin Sharp-Pierson, a strategist at BNP Paribas, estimates “that companies have bought back around 20% of market capitalization since Lehman’s collapse in 2008, or around $3.8 trillion using today’s equity prices.” Two-thirds of companies in the S&P 500 have lowered their share count in the past year, including more than one-fifth who have reduced it by more than 4%.
Historically, companies have borrowed to invest; i.e., to expand their workforce, upgrade facilities, or develop new products. However, new research indicates that over the past three decades corporate borrowing is increasingly being used to fund distributions to shareholders. According to data provided by Mustafa Erdem Sakinç of the Academic-Industry Research Network, since 2004 the companies in the S&P 500 have spent 54% of their profits on stock buybacks.
At BWFA, we only favor stock buybacks as a means of returning cash to shareholders when valuation is part of the decision to repurchase shares. Many management teams seem to use share buybacks most aggressively when they have the most cash. Unfortunately, that approach can lead to spending too much to buy back shares, which ultimately destroys capital. We also think that if a business has opportunities to grow in a way that benefits the firm’s long-term value, such investment should be prioritized over share repurchase. Effective capital allocation is one of management’s primary responsibilities. We play close attention to how management allocates capital when evaluating investment opportunities.