Beating the Buyback Blues

S&P 500 firms gave their shareholders a nice present last year: $477.6 billion in stock buybacks. Considering how up in arms headlines have been about the supposed piles of unspent cash on corporate balance sheets, you’d think they’d cheer this development, but in typical fashion, many saw this news as a flashing warning—a sign companies are using funny math to boost earnings, or an indication they aren’t investing in growth-oriented projects. It’s one of several false fears fluttering around these days—a bullish sign.

The logic behind the “funny math” argument goes like this: When a company buys back stock, the number of shares outstanding shrinks, giving earnings per share an easy boost—the numerator (earnings) is the same, but the denominator (share count) shrinks. Since most investors look at earnings per share, the naysayers claim their perceptions are artificially inflated by an accounting trick and say investors will see past this and only invest in companies with actual, organic earnings growth, driven by rising revenues. Fair enough. But there is no reason companies can’t have buybacks and actual earnings and revenue growth—and these days, they have both! Earnings and revenues have been rising! S&P 500 earnings rose approximately $21.1 billion and revenues about $20.9 billion y/y in Q4 2013—both are at all-time highs (and rising).^[i]

Sure, higher earnings per share is a benefit of buybacks, but companies don’t use them to hoodwink investors. The actual purpose is twofold. One, it’s a way to return cash to shareholders—instead of issuing a dividend, they buy shares, reducing supply, giving prices a tailwind. It’s Econ 101. Two, firms use them to boost finances. Balance sheets are probably the healthiest they’ve ever been, flush with cash reserves. But cash earns little interest, and companies (and shareholders) no doubt want at least some return on their liquid assets. So they can use that cash to buy up stock or use it as collateral to borrow cheap, buy their (theoretically) higher-yielding shares and pocket the spread. It’s largely a win-win for all involved.

Some say there are losers, though—namely, projects the company should be investing in instead of buying its own shares, and all the vendors, contractors and employees they’d pay in the process—future growth. One theory says it’s a sign companies fear a bleak future, drawing a parallel with the high number of buybacks in 2007. To which we say, no correlation without causation—no one saw that financial panic coming for the reasons it occurred. Higher buybacks then, like now, were largely arbitrage, and total business investment was just fine. Just like it is today—the private sector is investing plenty in the future. Business investment hit an all-time high in Q4 2013, coming in at $2.03 trillion—its previous high was $1.98 trillion in Q1 2008.^[ii] Both equipment ($954 billion) and intellectual property ($639 billion) investment hit all-time highs in Q4 2013 too^[iii]—companies don’t spend that kind of money if they forecast a poor business environment in the near future.

We don’t see any reason why investment should nosedive looking forward. It might wobble in the near term—short-term data always do, and winter weather likely had some impact on business spending—but longer-term, the backdrop for corporate spending looks good. The Leading Economic Index rose another +0.5% m/m in February, continuing its streak. New orders and order backlogs have been growing—manufacturers can’t keep up with demand, suggesting businesses aren’t slowing down. And with quantitative easing winding down, the interest rate spread should widen further—making bank lending more abundant and giving businesses even more capital to invest and grow.

But few see this. That’s bullish, folks. The buyback blues help lower expectations, extending the proverbial wall of worry stocks love to climb. As folks eventually realize reality is better than they believed, those false fears flip to rising confidence, which should propel stocks higher over the foreseeable future.