Are Buybacks A Bad Sign?

By Stephen D. Simpson, CFA | August 22, 2011 AAA

In the last decade or so, a common theme has emerged from U.S. boardrooms - when the going gets tough, companies start buying their stock. There are plenty of valid reasons for companies to repurchase their own stock, particularly when markets sell off and valuations drop. On the other hand, buybacks are not a terribly productive use of cash, and investors may be right to worry whether a spate of repurchase announcements in the face of a worsening economic environment is going to make things worse in the long run.

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Who's Doing The Buying?
The past few weeks have seen several large share repurchase announcements. Lockheed Martin (NYSE:LMT) and Lowe's (NYSE:LOW) take the cake with announcements of $1 billion and $5 billion plans, respectively. Maxim Integrated (Nasdaq:MXIM) is in for $750 million, Celgene (Nasdaq:CELG) added $2 billion to its plans, Marsh & McLennan (NYSE:MMC) is looking to buy back $1 billion, and Covidien (NYSE:COV) has a $2 billion plan in place.

Clearly that is a wide range of industries - defense, retail, semiconductors, biotech, insurance, and health care. Suffice it to say, then, that this a widespread phenomenon across the U.S. economy today.

Why Buy Shares?
There are several reasons for companies to look at buying back their own shares, and those reasons run from the sound and pragmatic to the craven and opportunistic. Clearly there is an economic rationale - it is not hard to show through models and equations that investors do better when companies return cash to shareholders when facing a lack of projects likely to earn their cost of capital. At the same time, buybacks can boost stock prices and ease the strident calls from institutional investors for management to "do something" about a languishing valuation.

There are other advantages to share buybacks that are not necessarily widely appreciated. For starters, buybacks are usually highly discretionary - companies can buy (or not buy) when they please and there is usually no legal requirement to fulfill an announced buyback program. Additionally, buybacks help neutralize some of the impact of extensive share option compensation plans.

Last and not least, investors can look at this as a way for companies to use offshore cash effectively. Right now there are billions and billions of dollars sitting in overseas subsidiaries of U.S. companies, but companies do not want to repatriate this money and pay the taxes. In many cases, though, creative companies can utilize this cash to repurchase stock and skirt (or delay) taxes. (For more on buybacks, see A Breakdown Of Stock Buybacks.)

The Downside
No good deed goes unpunished and no corporate action is free of consequences. In the case of buybacks, investors may have some reasons to be skeptical about whether these are good uses of capital and whether they may signal bad news ahead for the economy.

Think about the other side of the economic rationale of a buyback - namely, the lack of suitable expansion projects. What does it say about a company's growth potential if management can no longer find attractive reinvestment opportunities for its capital? Of course, there are exceptions and caveats here too - Apple (Nasdaq:AAPL) has not had to spend enormous sums to develop the iPod, iPhone, or iPad, and returning capital to shareholders here may simply acknowledge a superior business model that produces cash far in excess of it needs.

Another angle to consider, though, is that of jobs and capital expansion. Money going into the stock market to buy shares is money that could be used to hire workers. Using the averages provided by the Bureau of Labor Statistics, an average worker in the United States costs a bit under $59,000 a year in salary, taxes, and benefits - so a $1 billion buyback could be seen as equivalent to employing almost 17,000 workers for one year. Likewise, money spent on repurchases is not going to be spent on new machinery or trickle down through the supplier networks - and that has to have an impact on economic activity and the job market. (For related reading, see The Unemployment Rate: Get Real.)

What's The Answer?
Clearly it makes no sense to hire workers and buy equipment that will all simply sit idle; versions of that have been done in Japan and communist countries and it never works well. Simply put, markets work best when companies are free to allocate capital as they wish. The trouble, though, is that the feedback mechanisms that inform these choices are not always clear or unbiased - Wall Street famously rewards short-term thinking and will happily celebrate mass-firings and big buybacks with nary a thought spared for "gee, how is this company going to grow in the future?"

While it is arguably a wise idea to hold off on hiring and capacity expansion in the face of weak consumer spending and a very uncertain economic environment (one made worse by ceaseless political bickering), the truth is that it takes money to make money. Companies should certainly be encouraged to disgorge cash that they can no longer profitably invest, but before investors celebrate this outbreak of buyback announcements, they may do well to look a little more closely and see whether or not companies are short-changing their future growth potential (and hampering economic growth in general) just to make Wall Street happy for a couple of days.

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