America Is Paying The Price For Stock Buybacks

Includes: DIA, IBM, QQQ, SPY
by: Wall Street Daily

By Tim Maverick

The Federal Reserve often wonders why corporations don't invest more in their businesses.

It's certainly made an effort to spur such spending, keeping interest rates ultra-low for many years now.

And the low rates have had a dramatic effect on corporations. But not in the way the Fed anticipated. And not in a way that bodes well for the future...

Corporations have indeed gone on a borrowing binge. But they haven't been investing that borrowed money in the future. Instead, it's largely been spent on the financial engineering practice commonly known as stock buybacks.

Debt Binge, But No Investment

Weak capital investment is a major restraint on economic growth. It's a key reason behind the weak worker productivity readings lately. And it's the main reason, I believe, the U.S. economy has been stuck in neutral for so long.

And unfortunately, it's a trend that's accelerating. Capital expenditures by S&P 500 companies fell in both the second and third quarter of 2015 when compared to 2014 numbers. That hasn't happened since 2010.

Yet, corporate leverage is now at its highest level in 12 years. And credit rating downgrades account for the biggest piece of ratings changes for the first time since 2009.

The Federal Reserve reported that, in the third quarter of 2015, non-financial corporations owed $8 trillion in debt! That's up from $6.6 trillion three years prior.

So, where did all of this borrowed money go?

Stock Buybacks on Steroids

Much of it went to stock buybacks. A Reuters study showed that, since 2010, 60% of the nearly 3,300 publicly traded non-financial companies have bought back shares.

What's frightening is, Reuters found that of the 1,900 firms that have repurchased shares since 2010, buybacks and dividends amounted to 113% of capital spending. And in fiscal 2014, buybacks and dividends were higher than net income. That's never happened outside of a recession.

And the numbers involved in stock buybacks are enormous. In that same three-year period the Fed looked at, companies bought back $1.3 trillion worth of stock!

These short-term gains for shareholders are likely coming at the expense of long-term competitiveness for U.S. corporations.

Just look at what was once the worldwide leader in innovation, IBM Corp. (NYSE:IBM). It's the poster child for stock buybacks and the financialization of a company at the expense of research and development (R&D).

Now, revenue and earnings have been in decline for a few years. And its stock is still down - despite the recent rally - about a third from its peak in 2013.

The Beneficiaries - the 1%

One main direct effect of share buybacks is that it makes earnings per share look better, since the number of shares outstanding are lower. Since 2012, overall U.S. corporate per share profits are up about 6.2% annually. About 20% of those "gains" stem directly from share buybacks.

And corporate executives are the main beneficiaries of the sort of financial engineering that IBM and many others have engaged in. Many executives' compensation is directly tied to short-term performance measures such as - you guessed it - earnings per share (EPS).

Reuters analysis found that 255 of the S&P 500 companies reward executives in part on EPS performance. It found another 28 have other rewards that can be influenced by stock buybacks.

Additionally, 303 of the S&P 500 companies reward executives on "total shareholder return." That includes share price appreciation and dividends.

That's a great scenario if you happen to be one of those executives. Or maybe an activist fund manager. But for the rest of us, financial engineering has done little.

The runaway train that is stock buybacks is finally starting to stir some dissent.

James Montier of the GMO Funds in London told Reuters, "There's been an over-focus on buybacks and raising EPS to hit share option targets, and we know that those are concentrated in the hands of the few, and that the few is in the top 1%."

And the U.S. political elite in both parties wonder why so many Americans are drawn to Bernie Sanders and Donald Trump!

Some action is beginning to be seen on the political front, too. Democrat Senators Elizabeth Warren and Tammy Baldwin are calling on the SEC to investigate buybacks as a form of market manipulation.

That may be going too far. But adding in the widespread use of pro forma earnings and U.S. corporations' reported earnings numbers today really don't give a true picture of the health of the company.

It's a big reason why I often look overseas for investments. But the "financialization disease" is spreading there, too.

It was a lot simpler for investors before 1982. Corporations were prohibited from buying their own shares. And the financialization of corporate America by Wall Street hadn't happened yet.

But those days are long gone.

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