Stock buybacks are not always good deal for investors – USA TODAY

This post was originally published on this site

Anyone who made it through the stock market crash of October 1987 probably remembers the boost provided by share-buyback announcements.

Following the market collapse back then, big corporations stepped up with word that they would buy back their shares. Nearly two in five companies in the Standard & Poor’s 500 index declared they would purchase stock, helping to reassure rattled investors with a message that prices had dropped to bargain levels.

Ever since, investors generally have viewed buybacks favorably, though some recent research suggests buybacks don’t always help all that much.

Share buybacks often are mentioned in the same favorable breath as dividend increases as a tool management and directors can use to boost returns for shareholders, assuming a company has extra cash to take such actions. Buybacks reduce a company’s outstanding share total, giving an upward lift to earnings per share.

“Companies continue to use buybacks to add to their EPS at a time when EPS growth has become the center of attention,” noted Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, in a statement.

Compared with paying dividends, buybacks have certain advantages. One is flexibility, as companies can pursue buybacks as one-time actions, with no expectation they will continue into the future. That’s not so easy to do with dividends, where decreases and cuts are viewed with alarm.

Buybacks also can enrich shareholders without saddling them with a tax bill. By contrast, dividends generally are taxable for investors holding shares outside of IRAs, 401(k) plans and other tax-deferred accounts.

At any rate, buybacks certainly have become routine among larger, cash-rich companies. Slightly more than 300 of the S&P 500 corporations bought back shares during the second quarter, collectively spending $132 billion, according to S&P Dow Jones Indices. The $554 billion spent over the four quarters through midyear is a 12-month record.

The total jumps to nearly $700 billion annually when buybacks from all U.S. companies — not just the 500 or so largest — are counted, wrote Chris Brightman, Vitali Kalesnik and Mark Clements at investment-strategy firm Research Affiliates in an October study.

So what’s not to like about companies purchasing their own shares from time to time on the open market?

One argument against buybacks is that they could signal poor investment prospects for a corporation. After all, why return cash if you can invest internally at an attractive rate of return? Even worse, the cash spent on buybacks can starve future corporate operations and projects of needed capital.

But Tim Koller, a principal at McKinsey & Co., didn’t find much evidence of that in a recent paper. Rather, the trend to increased buybacks — they now exceed dividend payments by a ratio of 2-to-1 — largely reflects shifts in corporations themselves, he wrote in a commentary.

With the ascent of pharmaceutical, medical-device, technology and other intellectual-property entities, there’s less need for big capital investments focused around factories, heavy equipment and real estate. Intellectual-property companies account for 32% of corporate profits but only 11% of capital expenditures, freeing cash for buybacks, Koller wrote.

Certain companies might be investing too little in their future growth, and for them share buybacks could hasten a downward spiral. “But in aggregate, it’s hard to make a broad case for underinvestment or to blame companies returning cash to shareholders,” he said.

Koller also indicated that he found little evidence suggesting that the gradual increase in buybacks has held down growth for the overall economy, either.

A more skeptical view of buybacks was presented in the study by the three researchers at Research Affiliates. The common presumption, they noted, is that buybacks are good because they remove shares from the market. But if the same corporations also are issuing new stock separately, that would mitigate the benefits.

Why would companies issue new shares? One reason is to finance executive compensation as CEOs and other top corporate officials exercise stock options. “When management redeems stock options, new shares are issued to them, diluting other shareholders,” the authors note. “Buyback? Not really! Management compensation? Yes.”

Another reason is to pay for non-cash acquisitions of other companies. With some mergers and acquisitions, issuing new stock to make the purchase can dilute or erode the value of shares already outstanding. The purchase of one public corporation by another generally wouldn’t make much of a net impact because new shares of the one entity are being used to retire those of the other. But buying a private company with new stock, as with Facebook’s acquisition of WhatsApp, would represent new issuance and thus dilution.

Further, corporations sometime buy back shares at the same time they are increasing debt, which can make a company more risky.

Several giant companies that had some of the largest buybacks last year also engaged in some of the biggest stock issuance, including Cisco, Oracle, Johnson & Johnson, Wells Fargo and Merck, according to the report.

The researchers take a swipe at the occasional practice of adding a company’s buybacks and dividend yield together to generate a performance measure for shareholders. With buybacks representing 2.9% of the capitalization of S&P 500 companies and dividend yields at 1.9%, that suggests a combined 4.8% yield for shareholders.

But this number fails to include new issuance that offsets most or all of the former number. “We do not think that the naïve sum of dividends plus buybacks has merit,” the authors said.

Taken together, the report sees little overall benefits from share buybacks for mainstream investors.

“The reality is that publicly traded companies in the United States are issuing far more new securities than they are buying back,” the authors say. “In the aggregate … buybacks are simply a mirage.”

Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.

Read or Share this story: http://usat.ly/1NRTfua