Buybacks have put US corporations deeper in debt. Net US corporate debt is a record $2.3 trillion, up 14% in the last year alone. The combination of too much debt, slowing earnings and expensive shares are slowing the buyback stampede
The combination of free money and incentives for management has been irresistible for many corporations in the US. In the 12 months to 31 March 2014, US companies increased their spending on buying their own shares by 29%. Then bought $534 billion worth. This was surpassed on in 2007 when companies bought $589 billion. These buybacks have helped the US market reach new highs and increased earnings. So any end to the process may have a dramatic impact.
Buying a company’s own stock is the classic strategy for managers who can’t think of anything more productive to do with their cash. By reducing the number of shares outstanding they make earnings look better. There are more earnings for fewer shares. Increased earnings usually raise the price of the stock. Since managers are often on incentives to raise share prices, buybacks can look very attractive. They can be even more attractive when the corporation can borrow at rock bottom rates to purchase the shares.
Buybacks are also popular with shareholders. There is even an exchange traded fund (ETF) for them. PowerShares Buyback Achievers has returned 22.7% per year compared to 18.8% for the S&P. But there is a problem. Although the process does flatter earnings, it also increases debt. Often corporations are using debt to purchase expensive shares. So it is no way to grow a company.
Philip Morris, the American tobacco company is one example. Over the past five years, Philip Morris has been able to grow its earnings by more than 10% even though sales were flat. Higher earnings were created by price increases and cutting costs, but these were not sufficient to send its earnings into double digits. What did that were buybacks.
Since 2008, Philip Morris spent $56 billion on its own shares. This large amount did not come out of its $43 billion if cash flow. They had to borrow another $14 billion to pay for it. Without income and increasing debt, Philip Morris’s credit rating might be at risk unless as its chief financial officer (CFO) states, the company “will have to bring our cash outflow in line with our inflow”. In other words they will no longer be able to spend $2.7 billion more than their income on buybacks and dividends. No doubt there will be an impact on their stock.
It is not just Philip Morris. Buybacks have put US corporations deeper in debt. Net US corporate debt is a record $2.3 trillion, up 14% in the last year alone. The ratio of long term debt to assets is almost as high as it was at its peak in 2009. Profits have not kept up. The awful first quarter reduced profits by $198 billion and net cash flow by $120 billion. Commentators love to blame this on the weather, but overseas profits were also hit by $26 billion.
So, buybacks will probably slow because managers have maxed out the corporate credit card. But there is another better reason. It no longer makes sense. There might be some economic basis for purchasing undervalued shares, but it is just incompetent to buy them at the present valuations. US markets are trading at all time highs. Tobin’s q, a well regarded index of valuation, puts equities at 88% overvaluation. Robert Shiller’s cyclically adjusted price earnings ratio (CAPE) puts the overvaluation at 87%. Buying expensive stock with more debt is not generally a good business plan.
Analysts always lower earnings expectations as the year goes on. This one is no exception. Second quarter growth estimates have been lowered from 3.5% to 2.8%. The combination of too much debt, slowing earnings and expensive shares are slowing the buyback stampede. The number of US companies announcing plans to buyback shares in June was only 38 the lowest since 2011. The amount spent on buybacks last month was only $22.2 about a third of the $61.7 billion spent last June. Even the ETF Buyback Achievers is beginning to notice. It gained 8.5% this year compared to the S&P’s 14.9%.
Eventually even the present bull market will correct. Eventually interest rates will go up. So eventually buybacks will stop. Then corporate balance sheets loaded with debt will not look so attractive to anyone.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)