Buybacks add fuel to the share markets

 

It could be the biggest year on record for companies buying back shares on the market. Chris Smith looks at what this means for business and investors.

Figure 1: Value of US buybacks in 2018

JUNO_Share Buybacks Graph.jpg

 

After a slowdown in 2017, companies are once again choosing to use surplus capital to buy back their own shares, with US$650 billion in buybacks projected for 2018 – a 23 per cent increase on 2017, according to Goldman Sachs research.

Decisions by companies to buy back shares are nothing new in the financial markets, and they’ve been a winning, long-term business strategy for decades.

Wall Street loves buybacks. But what about the effects of buybacks on shareholders and employees? Some commentators are worried that workers won’t see their share of the gains being made by business.

Looking back… and forward

The bottom of the Global Financial Crisis (GFC) in March 2009 saw the lowest period of corporate buybacks in recent history – but this has risen ever since, as companies look to invest internally and improve earnings-per-share growth. 

US companies have bought back more than US$3.1 trillion in shares since 2010, supporting the bull market. Over the same period, more than US$2 trillion in dividends was paid out to investors. 

Cisco is a good example. In February, Cisco announced plans to use US$25 billion of the US$71 billion cash it holds offshore to buy back its own shares. This amounted to about 14 per cent of the firm’s entire market capitalisation.

Although Cisco consistently invests in research and development, imagine the growth opportunities that offshore capital could have created to help an investment boom in America – now and in the future.

On the other side of the equation, many corporates have high cash flows but limited investment-growth prospects. Buybacks are an efficient use of capital in this case, and an attractive option because they improve returns for both shareholders and balance sheets.

And businesses that invest the most in their own future growth should outperform over time.

But one of the arguments against buybacks comes when some companies raise new debt at record-low interest rates, and then go on to buy their own shares, because the return on their capital is greater. This has been a key reason corporate debt continues to rise.

Impact of US tax cuts

In February, the White House announced significant tax cuts, which are intended to grow US business. President Donald Trump’s tax reforms are of major significance for corporate America. The US has long been out of step with its global peers, unable to incentivise its own companies to bring back most of the trillions parked in offshore bank accounts. 

Tax cuts have ignited a new boom in buyback announcements in the most recent earnings season, along with reports of growth in capital expenditure. 

The focus of the reforms was always to support Middle America and to help corporate America be more competitive, and make available new investment expenditure. 

This should translate into more jobs, pay rises, and bonuses for staff. But the unintended consequences may be that more capital is returned to the higher-income investors in businesses (shareholders).  

Awash with capital

Goldman Sachs reported capital expenditure in corporate America will grow by 11 per cent to US$690 billion in 2018, remaining the largest single use of cash. Companies such as Johnson & Johnson, Apple, and 3M have all committed to large investment-spending increases over the year. 

Mergers and acquisitions will also increase this year, to more than US$360 billion, and shareholder dividends are expected to grow by 12 per cent, to US$515 billion. 

It’s clear from the figures that there’s no shortage of capital in the system being returned to investors, helping the capital markets, and keeping investment bankers and brokers busy.

Attitudes towards buybacks

Buybacks are widely debated and viewed differently by those in the markets. 

Larry Fink, from investment giant BlackRock, recently suggested that buybacks are  “preventing corporate America from investing on longer-term growth opportunities and therefore crippling the economy”. 

He believes too much capital and tax savings have been given to investors and shareholders, and not enough investment is going into growth projects. 

Warren Buffett’s company, Berkshire Hathaway, will execute a buyback only if shares fall a certain amount below book value and are, in essence, too cheap. 

It bases this policy on the logic that it makes sense to buy back at a low valuation, rather than at a high point. Of course, with the rapid rise in the share market, this threshold has not been met for several years. 

Berkshire Hathaway now has a cash holding of more than US$100 billion to use for investment opportunities. 

But in cases where a business has limited options to buy another firm, or invest in staff and operations, a buyback makes sense. It can consolidate the shareholder base, improve return-on-capital metrics, or give capital back to shareholders in the form of regular income dividends.  

Alternative options to buybacks

Instead of buying back its shares, what could companies do? They could:

  • Pay down existing short- and long-term debt; company debt now stands at more than US$51 trillion dollars.
  • Pay a special dividend to shareholders.
  • Put money aside for employee pension liabilities. For example, General Electric has the largest pension liabilities of any S&P500 company, and funds a lot of this with borrowings.  
  • Invest in the business itself, through new manufacturing facilities or offices, and installing technological upgrades to systems.
  • Invest more in new and existing staff.
  • Fund mergers and acquisitions. 
  • Improve margins, to help grow earnings per share organically.

Many businesses have the ability to do all of the above, as well as buy back shares. Apple, for example, is a cash flow-rich business with pressure on how to use its capital most effectively and efficiently for its shareholders. It recently announced its largest-ever programme of US investment, following the tax reforms.

Only time will tell how the tax-policy changes will affect overall economic growth, and how much is divided between shareholders and workers. 

One thing is certain – when buyback amounts do drop back, it will be because companies have probably found a better use for their capital. 

Definitions: 

Buyback: Share buybacks are when a business repurchases a portion of its own outstanding shares. This reduces the number of shares available and increases earnings per share. The company pays the current market value per share, on the exchange or privately, to remove them from public or private ownership. This, to some extent, consolidates ownership. 

Capital Expenditure: Capital expenditure (capex) is the money used by a business to acquire, upgrade, and maintain physical assets such as property, buildings, businesses or equipment. The business often uses capex to take on new projects or investments. 

First published Autumn 2018

Story by Chris Smith, CMC Markets

Disclosure: The author does hold shares in Apple, which is mentioned in this article. This article should not be considered financial advice.

The editorial above reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.


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