What Happens When the Buyback Boom Ends?

By Chris Lowe, Editor-at-Large on November 26, 2014



Source: Pixabay

In another report straight out of Fantasy Land, Goldman Sachs estimates that US companies will buy $450 billion of their own stock this year.

And that pace of buybacks is nothing new. Over the past four quarters, US companies have bought back $560 billion of their own stock.

Half a trillion bucks doesn’t mean much out of context. But according to the Financial Times, it’s 50% more than mutual funds and ETFs will buy in 2014.

This helps explain why the US stock market has been so buoyant lately. A report by Barclays estimates that buybacks added more than $2 a share to S&P 500 earnings under the Fed’s QE.

When a company buys back its shares, it uses cash or debt to buy outstanding shares and cancel them. This reduces the amount of shares available to the public. And it increases the earnings per share of its outstanding float.

Over the short term, that’s a good deal for shareholders.

Over the last five years, for example, the PowerShares Buyback Achievers Fund ETF (NYSE:PKW) – which tracks US companies that have bought back at least 5% or more of their outstanding shares over the previous 12 months – has returned 136%. That compares to a 90% return for the S&P 500.

But this is not a free lunch. Every dollar companies spend on reducing their share counts is a dollar not spent on hiring new workers, maintaining factories and machinery, and researching and developing new products.

This jeopardizes sustainable long-term stock market returns.

Share buybacks boom when interest rates are low. That’s because low rates allow companies to take advantage of the low interest to directly prop up share prices.

Apple is a great example. Over the last year and a half, Apple has raised $29 billion by selling debt at ultra-low rates of interest. This has helped fund $50 billion in share buybacks.

Like all financial engineering, this feels great to begin with. Shareholders see the price of their shares go up. And corporate managers receive fat bonuses – which, for the majority of senior executives, are linked to the performance of the shares of the companies they work for.

But what goes up must come down…

Like all other booms, the buyback boom contains the seeds of its own destruction. Buybacks push up stock market valuations. As valuations rise, buybacks become more expensive.

This depletes companies’ stockpiles of cash at a faster pace than at lower valuations and offers less and less value for shareholders.

It’s no coincidence that the last time there was a buyback boom, buybacks peaked at almost the top for the stock market – in Q3 2007.

This time, too, fantasy will eventually give way to reality…

P.S. Bill’s new book, Hormegeddon, also explains why financial engineering and central planning are doomed to fail. Here’s that link again to pick up a copy.

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