Stock buyback trend bad for the economy?

Photo courtesy of Davis Nitzsche on Flickr

Photo courtesy of Davis Nitzsche on Flickr

Rob Swystun, Pristine Advisers

Stock buybacks may be good for getting numbers on a screen to go up and down in the right direction, but they may be hurting the general economy in the long run, Wall Street analysts say.

Stock buybacks are set to hit an all-time high this year. $1 trillion, in fact. As Xavier Brenner of Covestor points out, loads of big companies like Apple, Coca-Cola, Allstate, McDonald’s, Northrop Grumman and Monsanto  are returning some of the fat stacks of cash they have lying around to shareholders.

Buybacks are good for shareholders who appreciate the cash. And, according to Bloomberg’s numbers, they tend to be good for companies, as S&P 500 companies that have issued buybacks have outperformed the market since the first quarter of 2009.

But, critics of the practice have said that it harms the overall economy by:

  • artificially propping up the market,
  • discouraging CEOs from reinvesting in new job-creating ventures, and
  • contributing to the ever-widening wealth gap in the United States.

Buyback Binge

University of Massachusetts Lowell economics professor William Lazonick says from 2003 through 2012 almost 450 companies in the S&P 500 index spent 54% of their earnings ($2.4 trillion) buying back their own stock, plus dividends accounted for another 37% of their earnings.

Lazonick says that $2.4 trillion could have gone toward things like new factories and businesses that would have increased jobs and wages.

In addition to that, buybacks distort corporate earnings numbers by reducing the number of outstanding shares and increasing a company’s earnings per share. When profit margins are rising, this doesn’t have a huge impact, but it does when margin growth stalls, as has been the case in the last few years.

According to Bloomberg Businessweek, Wall Street analysts had predicted that profits would be down by 6.5% in the second quarter of this year, but if companies weren’t buying so much of their own stock, the drop could be as much as 9%.

“It makes you rethink a lot of things,” Kevin Mahn, president of Hennion & Walsh Asset Management said told Bloomberg. “We question how much earnings growth has taken place because of actual sales growth and consumer spending—and how much is attributable to buybacks.”

Companies in the S&P 500 bought more than $550 billion of their own stock in 2014, inflating EPS growth by 2.3 percentage points.

It should be noted that not everyone sees buybacks as a bad thing, with Dan Greenhaus, chief global strategist at BTIG, which provides trading services to institutional investors, saying they can be justified if a company’s stock has been undervalued.

“Today the argument is buybacks are distorting the market, but I’m less certain,” Greenhaus said. “To the extent companies have thought their shares are undervalued the past few years, buybacks have been a fair use.”

Stock Option Culture

Fueling the buyback trend — at least partially, according to some analysts — is that old, familiar friend of Wall Street; executive greed.

As 80% of executive compensation comes from bonuses and stock options (way up from 20% 30 years ago), co-founder and chief investment strategist of Grantham Mayo van Otterloo Jeremy Grantham said at the 2015 Morningstar Investment Conference, it has lead to a “stock option culture” where profit maximization trumps long-term capital investment.

“For a senior management person to use the cash flow as a corporation to buy stock back is much less dangerous than building a new plant,” he said during his keynote address at the conference.

For companies with extra cash burning a hole in their pocket, buybacks will likely continue to look like a safe and easy option to spend it on.

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