As dividends and stock buybacks reach their highest levels since 2007, criticism of corporate efforts to return cash to shareholders is emerging. Skeptics contend that the announcements are designed to boost earnings per share and stock prices, and that money would be better spent on business reinvestment and hiring new workers.
My view is that much of this criticism is misplaced. Rather than an attempt to boost earnings per share, I believe the efforts to return cash to shareholders are an outgrowth of an uneven US economic recovery and accommodative monetary policy, and that corporations are continuing to reinvest in their own businesses at a healthy rate.
The buyback binge
At the end of the second quarter, 75% of all companies in the S&P 500® bought back shares and paid dividends in the trailing 12 months, according to data from FactSet, while $555.5 billion was spent on share repurchases in the same period.1 We’ve seen a steady stream of large, well-known companies such as AIG, Wendy’s and Apple announce buybacks, garnering a lot of media attention. Politicians have questioned whether companies are favoring buybacks over building new factories or giving raises to workers. As a result of this activity, by the end of June more than 20% of S&P 500 companies had reduced their share count by at least 4% year-over-year in each of the last six quarters.2
One of the factors driving the buyback trend is the incredibly accommodative monetary policy environment we’ve been in since 2008. Companies are taking advantage of the fact that the Federal Reserve has kept interest rates near zero to borrow money to buy back shares.
Record corporate profits are also driving buybacks. Corporate profits are at an all-time high, having increased for the past six years.3 Rather than keeping cash on their balance sheet, where low interest rates mean it doesn’t have the potential to generate much in the way of returns, corporations are putting the cash to work by repurchasing shares and returning money to shareholders.
It is true that buybacks help boost a company’s earnings per share (EPS) on a nominal basis. However, they are not the sole driver of record corporate profitability, especially when it comes to the S&P 500 Index.
According to S&P Dow Jones Indices, buybacks do not increase the EPS of the S&P 500 Index due to the index’s weighting methodology. The index reweights for major share changes on an event-driven basis, and each quarter, it reweights the entire index membership. This helps negate most of the share count changes and reduces the impact of buybacks on EPS.4
At the secular trough in 2009, the trailing 12-month EPS for the S&P 500 fell to $40. It has now risen to $108, which is a gain of 170%. In the same period, the S&P 500 has increased about 190%. The truth is that the gains in the S&P 500 are built on profits—not buybacks.5
Capital expenditures remain at historic levels
As a result of record profits, US corporations have about $3.6 trillion in cash and marketable securities on their books.6 Despite these extremely high levels of cash, it’s true that corporations have been cautious about investing. Corporations, just like individual investors, are contending with multiple unknowns, including the future path of interest rates and the strength of the US economic recovery. Global turmoil, ranging from this summer’s escalation of the Greek debt crisis to slowing growth in China, has also irritated the markets. As a result, corporations may be more reluctant to increase business investments than they have been in the recent past.
However, it’s important to understand that simply because executives are reluctant to invest doesn’t mean they aren’t reinvesting in their businesses. The percentage of cash flow that companies are using on capital expenditures (capex) is currently 40%.7
Source: US Census Bureau Annual Capital Expenditures Survey 2004-2013
As the “Capital Expenditures” chart above shows, post-recession capital expenditures have been steadily increasing since 2009. Consistent with the slow and steady US economic recovery, corporations have been demonstrating greater confidence by reinvesting in their businesses and making longer-term capital investments. This is pushing up capex figures as a percent of cash flow.
In today’s economic environment, I would argue that reinvesting 40% of free cash flow is a prudent use of capital. In addition, data from the National Science Foundation shows US business investment in research and development has risen in recent years, outpacing overall economic growth and historical trends.8 At the same time, data from the Federal Reserve shows private capital investment is increasing and stands at historically high levels of gross domestic product.9
So why do I think the buyback criticism is misplaced? Rather than using buybacks to inflate earnings per share or stock prices, I believe US corporations are taking part in the capital allocation process and deploying money where it is most effective. In today’s uncertain environment, companies that find themselves with more capital than they can invest productively are choosing to do what is prudent: returning profits to shareholders.
1FactSet, “Buyback Quarterly,” as of 9/21/2015
2S&P Dow Jones Indices, as of 9/24/2015
3FRED Economic Data from Federal Reserve Bank of St. Louis Economic Research
4Indexology Blog, “Buybacks and the S&P 500 EPS,” by Howard Silverblatt, as of 3/7/2014
5“The Wall” by Jawad S. Mian, as of 10/21/2015
6“Stray Reflections” by Jawad S. Mian, as of 5/31/2015
7“Stray Reflections” by Jawad S. Mian, as of 5/31/2015
8“Logical Song: What to Make of Record Buybacks,” Liz Ann Sonders, as of 9/23/2015
9“Logical Song: What to Make of Record Buybacks,” Liz Ann Sonders, as of 9/23/2015