Share buybacks by US companies ensure that “earnings” are high and rising

Most companies are swimming with money that they could use to expand their businesses. Instead they choose to repurchase shares. So is a buyback good for a company? By reducing the number of shares outstanding earnings are spread around among fewer shares

Although the American market is off about 3% in the last few weeks, the bulls will assure you not to worry. US earnings are very high and rising. They are at a record, 16% above their pre-crisis peak from 2007. Still this does not mean that they are overpriced. Their average price earnings ratios are not far above their historical average of 15. Earnings are forecast to continue to grow. Forecasts over the next 12 months for the US are supposed to rise by 20% above their pre-crisis peak. The bulls also point out that although the US Federal Reserve may slow the stimulus, it probably won’t stop it. The probability of an interest rate rise is far in the future. So the rally still has a long way to go. Or does it? Is there something more to the record earnings?


The problem with the record earnings is that they are not matched by record revenues. According to Reuters revenues are exactly flat, up 0.0% for the first quarter of last year. This presents a paradox. How can you get high earnings growth without revenue growth? One way is always to cut costs, but companies have been energetically slashing costs since the crash. There is always a limit to how much you can cut. Leverage with cheap Fed, money is always helpful. By gearing up the company, you can increase margins on fewer sales. But there is another way to use the cheap money: stock buybacks.


Stock buybacks have reached levels last seen before the recession. Stock buybacks peaked at $589 billion in 2007. They did not get that high last year. Companies spent only $408 billion on share buy backs. But the level of buybacks is increasing. In the first quarter of 2013, announced buybacks reached $214 billion, which if continued would easily outstrip the previous record. The trend is broad including some famous names. Apple recently announced a record $60 billion buy back. Blue chip firms like Merck, Wal-Mart and IBM have announced buybacks as have Sirius XM, Safeway the American grocery chain and CVS, a pharmacy chain.


Most companies are swimming with money that they could use to expand their businesses. Instead they choose to repurchase shares. So is a buyback good for a company? It always seems so. Most announced buybacks result in a rise in the company stock. Share buybacks in the US is tax favoured. Paying out extra cash as dividends will result in ordinary income to the shareholder, which is taxed at a rate higher than the capital gains resulting from the purchase of a stockholder’s shares.


Buybacks at the right time can also be useful. If management thinks the shares are undervalued it makes sense. This argument hardly applies today. Most developed countries’ markets are up over 20% this year alone. It would be hard to argue that they are cheap.

But there is a downside to buybacks, in that money used for buybacks might be better used for research and development, expanding the business or replacing ageing assets. For example Dole Foods supplies much of the US with many types of fresh tropical fruits. On 9th May it announced a $200 million share buyback. Almost a month later the board changed its mind and decided to update its shipping fleet with the acquisition of three new specially-built refrigerated container ships for its US West Coast operations, costing approximately $165 million. These new ships replace the present ones that are 27 years old.


A buyback often boosts companies’ shares, but the bump may not last. Studies show that companies that spend the most on share repurchases tend to underperform, because they don’t invest enough in operating or building their businesses for the long-term.


Share buybacks have another effect. They increase earnings. By reducing the number of shares outstanding earnings are spread around among fewer shares. So after a buyback earnings will increase even though profits are flat. It is estimated that buybacks have contributed nearly a fifth to the growth of per share earnings.


This last reason may be cause for some scepticism about the motives for share buybacks. Executive compensation is often tied to the management’s ability to meet per share earnings targets. If revenues are stagnant an easy way to meet the goals is to borrow a lot of money and buyback shares. Research shows that companies that tie executive pay to per share earnings are more likely to use accelerated share repurchases.


For example, the American grocery store chain, Safeway, has been experiencing a lot of competition from Wal-Mart. Its sales are flat and its margins narrowed. Nevertheless it experienced a 61% rise in per share profit last year. These did not come from cost cutting or rising revenues. The jump in earnings was due to an aggressive a $1.2 billion share buyback that reduced its outstanding shares by 28%. The buyback was funded with cheap money thanks to interest rate suppression by the Fed. Its shares have risen, but one of the largest beneficiaries was the CEO Steven Burd who was awarded a $2.3 million bonus.


Share buybacks can distort prices another way. With fewer shares on the market, lesser shares are traded. Liquidity dries up. A smaller number of trades can have a larger effect on the price of the stock. But it goes both ways. This year it has pushed stocks up, but it can also push stocks down just as fast.


Corporations are also very bad at timing. Rather than buying low and selling high, they do the reverse. Share buyback peaks and troughs align nearly perfectly with peaks and troughs of the S&P 500. This is for a very simple reason. In good times when the market is high, companies are flush with money and can buy their own shares. When the market is down, there is less cash for repurchases. So the present rally has been both fuelled by share buybacks often at record prices.


There is another conflict of interest associated with share buybacks. Large buybacks usually are correlated with high volumes of insider trading. A normal ratio of selling to buying by corporate insiders is $8 worth of shares sold for every $1 bought. According to TrimTabs Investment Research, this February insiders sold $35.50 worth of shares in their own companies for every dollar they bought. This is the highest monthly ratio since the firm began tracking the data in 2004. So insiders are in part-selling their own expensive shares to the companies they manage.


According to estimates share buybacks may have pushed earnings and hence their market value up 40% higher than they actually are. Much of these buybacks were accomplished with cheap QE stimulus funds. This was part of the purpose of QE, to raise stock market prices and encourage consumer spending through the wealth effect. Sadly the wealth that the stimulus has created might be simply an illusion. When the Federal Reserve and other central banks start winding down their stimulus programs, which they must do eventually, we will find out how much actual wealth there is. Even if they don’t, firms can’t keep using buybacks to boost their earnings. Eventually they have to grow profits. If they can’t, because the stimulus has failed to actually grow the economy, then the magic will definitely be over.


(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.)

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