When companies buy back their own stock, it’s generally seen as an investor-friendly sign of confidence. It allows shareholders to cash in on the company’s prosperity, and it signals executive confidence. After all, who knows more about a firm’s prospects than the insiders who authorize the purchases?
But in today’s uneasy market, stock buybacks have suddenly taken on a sinister cast. The Wall Street Journal leads today with an article by Ian McDonald about the alarmingly high level of stock buybacks. Armed with new data from Standard & Poor’s, he notes that in the year ended March 31, constituents of the S&P 500 “spent a record $367 billion” on stock buybacks, including more than $100 billion in the first quarter of 2006.
The theory is that executives may be spending all that cash on their own stock because they can’t think of anything better to do with it. Instead of using cash to build a new factory, or invest in India in a big way, or increase research and development, CEOs are spending money on paper. That’s the corporate equivalent of punting on third down and five. As Byron Wien, the longtime stock strategist turned hedge-fund manager, asks rhetorically in the Journal: “When buying back your own stock is the best use of capital, where are the long-term growth opportunities?”
But this critique of stock buybacks isn’t entirely convincing. As noted in this space, the last several years have been really kind to big public companies—weak labor unions and labor markets, a business-friendly president and compliant Congress, low interest rates, and repeated tax cuts. Between 2001 and the fourth quarter of 2005, corporate profits rose from 7 percent of GDP to a whopping 11.6 percent. The Journal today notes that the S&P 500’s members collectively hold cash worth 7.4 percent of their market value, a figure that “is nearly triple the level of 1999.” It’s not at all surprising that buybacks have risen sharply. The massive rise in corporate spending on corporate stock is roughly proportionate to the massive rise in cash sitting in corporate bank accounts.
What’s more, many stock buybacks are automatic and not the result of any executive’s decision. Companies that issue large grants of stock options and restricted stock have to continually repurchase stock to avoid dilution, as I noted in 2003. Intel, for example, spent $10.6 billion buying back stock in 2005.
And when it comes to making investments, sometimes buybacks signify cautious wisdom rather than cowardice. The Journal article notes that three gigantic companies—Exxon Mobil, Microsoft, and Time Warner—among them spent more than $14 billion on their own stock last year. But the nation’s biggest oil company, a humongous software company that has had serious antitrust issues, and a conglomerate still trying to dig out from a disastrous transformative deal face serious challenges in making massive investments quickly. Imagine the hackles that would be raised by shareholders (in Time Warner’s case), or by government officials (in ExxonMobil or Microsoft’s case) if these firms deployed their cash piles to buy competitors, or to try to monopolize a new market.
That said, there are reasons to view stock buybacks with suspicion. First, when it comes to their own shares, many companies are worse investors than the public. Members of the S&P 500 spent more money on their own stocks annually in 1999 and 2000, when stocks were at multiyear highs, than they did in 2001, 2002, and 2003, when stocks were generally low. These days, too, companies may be buying at the wrong time. Again, look at Intel. The company has spent $35 billion on buybacks since the end of 2000 and has lost a ton of money on these purchases as its stock has endured a lengthy slide.
Second, stepped-up buybacks can signal pessimism. Part of what’s unsettling the stock market is the perception that it will be very difficult for companies to increase earnings at the same remarkable pace of recent years—thanks to inflation, higher energy costs, and interest rates. Stock investors value companies in large part based on anticipated earnings. But they don’t simply look at total earnings, they look at earnings per share. By using buybacks to shrink the number of outstanding shares, companies can distribute the same or marginally higher earnings over a smaller number of shares. Voilà! Instant earnings-per-share growth!
Finally, corporate buybacks only tell half the story. On Wall Street, every buyer is matched with a seller. But what if those sellers are people who are intimately involved with the business? The Journal today flagged the example of Marvel. On May 31, Avi Arad, who stepped down as CEO and made a producing arrangement with the company, sold 3.15 million shares in the company, valued at about $60 million. At the same time, Marvel was spending $100 million buying back the stock. When insider sales coincide with big corporate buybacks, it leaves the impression that the company is using shareholder’s funds to help big-shots cash out.