Stock Buybacks: Fun, But Not For The Faint-Hearted

There’s nothing stockholders like better than companies that buy back their own shares, and the reason is obvious: These purchases boost the price of the stock. At the same time they also help management by improving various financial ratios, which entitles it to bonuses. So at the end of the day everyone is happy, but a question still remains: Are stock buybacks a productive way for companies to spend their money?

For most of the 1900s, corporate buybacks were considered a form of market manipulation and were illegal. However, this changed in 1982 when the SEC gave companies the green light to make these purchases. Since then they have become extremely popular.

In recent years, numerous companies borrowed great amounts of money at very low interest rates and used those funds to buy their own shares. In the three years ending in 2012, 449 companies in the S&P Index used on average 54 percent of their earnings – $2.4 trillion – to purchase their own stocks according to one study. Between 2008 through 2017 this number swelled to more than $4 trillion.

In 2016, a whopping 66 percent of corporate earnings went into stock buybacks.  In 2017 alone companies spent well over $800 billion on buybacks, a new record. Earlier in 2018, companies that received tax breaks from the Trump administration’s new tax law stepped up their stock purchase plans, pushing the market to all-time highs.

However, the question whether this is an efficient use of money remains. After all, those buybacks didn’t make even one company more efficient or competitive. 

Instead, what those companies could have been doing is plowing those funds back into R&D to develop new products, modernizing their production, making strategic acquisitions, expanding into new markets, or streamlining their businesses. They could also have held onto those funds in case of a rainy day, allocated them for opportunities that may come along, or given them to shareholders in the form of dividends.

Of course, these measures also would have boosted the price of shares in the long term, but companies wanted to realize these results quickly and easily.

Senator Elizabeth Warren (D-MA) is not impressed. Warren said in an interview with the Boston Globe that “Stock buybacks create a sugar high for the corporations. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that.”

The Shock Market

In 2017, Arne Alsin, an accountant who works in investment management, wrote this in Forbes: “Consider the case of American Airlines, a company two years out of bankruptcy, facing $19 billion in debt and continuing to buy back billions of dollars’ worth of company stock. You have to ask: Is that really the best use of company cash?

“Another example is Hewlett-Packard. In the last decade the company has invested $47 billion in stock buybacks, which is nearly double the company’s (then) market cap. This risk is senseless. HP knows they are facing existential threats from upstart competitors, but instead of paying out dividends or letting cash accrue on the balance sheet, HP is choosing the riskiest option. Shareholders never saw one dime of that $47 billion.”

Other giant firms also have traveled down this road and are paying an expensive price. General Motors, anticipating a weakening auto market, announced in November they would be halting production at a number of their plants in the U.S. and in Canada and eliminating more than 14,000 jobs; this restructuring will cost nearly $3.8 billion. GM, however, doesn’t have all that money on hand, so in order to downsize it will have to borrow money and go deeper into debt.

Critics suggest that had GM used its assets more wisely over the years, restructuring its business may not have been necessary – certainly not at this point in the business cycle. And they may not have needed to borrow any money. In the past four years, GM spent a whopping $13.9 billion on stock buybacks, which helped the stock price. Unfortunately, the boost was temporary, and fundamentals have caught up with boardroom wizardry. The stock is now 10 percent below the price it was four years ago.

A General Facing Defeat

The story at General Electric is even more ominous. At one time this company was considered one of the bluest of the blue chips, and its stock highly rated for both safety and growth. More recently, the impression is a drastically different one. In early December, GE’s stock was trading just over $7/share, down more than 60 percent this year; back on Jan. 1, 2016, the stock was nearly 32.

Even in good times, critics hung the epithet “buy high and sell low” on GE, referring to its poor timing when both purchasing and selling assets. Unfortunately, the company’s recent stock buybacks lent additional credence to this label. 

Between 2015-17, GE spent an incredible $40 billion repurchasing its shares at prices ranging between 20-32 – not very timely moves to say the least, as the company lost substantially more on those stock repurchases than it made from operations. As of September 2018, GE’s net worth was a negative $48 billion, and debt was approximately $100 billion.

The Bottom Line

There’s a famous expression that hindsight is always 20/20. When management buys back stock, this gives shareholders an opportunity to gauge how capable it is. For example, they can easily check how the stock has performed since then. If the current market price is higher than the purchase price, then management may have made a good decision; but if the price of the shares has declined sharply, management may have wasted a great deal of shareholders’ money.

Many financial websites question the wisdom of all stock buybacks, and some take this a step further, suggesting they are nothing more than Ponzi schemes that will end badly. 

Peter Schiff, a market commentator and CEO of broker-dealer Euro Pacific Capital, is very concerned about the possibility that interest rates will continue to rise.

Schiff warns that if they do, corporations that financed stock repurchases with debt may “have to sell their stock to repay the debt they cannot afford,” he said. “That’s going to end up destroying a lot of shareholder value if corporations have to sell equity into a bear market.”

Sources: bloomberg.com; forbes.com; marketwatch.com; prepareforchange.net; reddit.com.

 By Gerald Harris