Buying Back the Future

Are stock buybacks a good idea?

Photo Viktor Hanacek. Source: Picjumbo

When companies generate extra cash, they can do four different things with it. They can invest in their own business, through capital expenditures, they can invest in another business, via mergers and acquisitions, they can pay dividends to shareholders, or they can buy back their own shares.

Investors tend to like dividends and buybacks. It puts money in their pockets, rather than sitting in the corporate treasury. When excess cash builds up, there’s always a risk that the company will do something foolish with it, like Microsoft buying Nokia – a dying cell phone maker – for over $4 billion. Now Microsoft had almost $80 billion in cash on its balance sheet, so what’s the big deal? But that cash belongs to investors, not management. The stock fell by almost 20% after the announcement.

But are buybacks any better? When companies pay dividends to investors, investors get cash in exchange for a more risky investment. The stock is just a little more levered, but investors now have that cash under their own control. When companies buy back their shares, the stock is more levered, and the remaining investors get … what? An increased ownership stake in a financially more risky company. Is that a good thing?

It’s good if the company continues to perform well. Over the past five years, Microsoft has purchased $43 billion of its own shares, even as revenues grew from $70 billion to $85 billion per year. IBM, by contrast, has bought $44 billion of its own shares, even while its revenues have fallen from $104 to $80 billion. The money IBM has poured into its own stock has disappeared – it’s gone to “money heaven.” Their market cap has decreased by over $50 billion during this time. If IBM manages to turn things around, their buybacks will seem smart. But if revenues keep declining, IBM could end up like Dell – spending over $40 billion for a company that eventually went private for $14 billion. What a waste!

Dell share price. Source: Bloomberg

Big hedge funds love buybacks. They provide liquidity for their positions so they don’t move the market so much when they sell their stakes. But for the remaining shareholders, buybacks are like a call option. If the business prospers, that additional leverage can be a turbocharger the company’s returns. If not, well …

Since 2010, over $3 trillion of corporate cash has gone into buybacks in the US stock market. Time will tell if those call options expire worthless.

Douglas R. Tengdin, CFA

By |2017-07-17T12:21:18-04:00May 23rd, 2017|Global Market Update|Comments Off on Buying Back the Future

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