As an analyst that focuses on mREITs, book value has often created compelling arguments for buybacks. Outside of the sector, I see some substantial problems with the growth in buybacks over the last few years. While the S&P 500 performed very well, share prices don't tell the entire story. Most investors are aware that buybacks tend to peak around the time of a market crash and then fall off dramatically at the much lower prices that follow. This tendency is enough to make many investors question the competence of management across the entire corporate sector since buybacks are either timed poorly, or at least appear to be timed poorly. The point of this article is not to argue about the timing of the buybacks, it is to discuss the implications of the buybacks on a national level.
Two Uses for Cash
Beyond paying the ongoing expenses of current operations, there are two other major ways that a corporation might spend the cash they earn. The company could either return capital to shareholders or they could invest it an attempt to grow the business.
These different uses for cash can be further broken down into a few fields. The first area I want to look at is the option to return cash to investors. This is an area that activists frequently demand management pursue more aggressively. They want the company to send cash back to shareholders through either dividends or buying back shares. The more common headline is an argument for buybacks.
The other option for using cash is investing in future productivity and growth. That technique usually takes the form of either R&D spending or capital expenditures, though it can also be strategic acquisitions for new technologies that the company believes they can monetize effectively. Since M&A (mergers and acquisitions) could be a great strategy to expand production through better technology, it is arguably an investment in future productivity. On the other hand, if an acquisition is funded by paying cash to shareholders of the other corporation, the net effect is still sending cash directly back to shareholders. The cash won't go to shareholders of the surviving company, but it still demonstrates a way that M&A is not necessarily an investment in expanding production.
Demonstrating Cash Usage Via Brilliant Charting
The following chart created by Compustat and Goldman Sachs demonstrates the relative use of cash across the S&P 500 since the start of 1999:
This is an exceptional chart because it incorporates so many elements at once. We can use the scale on the left hand side to see the total amount of cash flowing out of the corporations to these uses. The total has clearly risen over time, but the chart is designed to assess the percentage of the total cash that was used so that the chart can also be viewed on a relative basis. It is important to recognize that the percent dedicated to growth has fallen significantly over time.
At the start of the century we had a fairly substantial problem where stocks were overvalued on the expectation for future earnings from investments in technology. It shouldn't be surprising that the amount of capital being invested was at fairly high percentages. On the other hand the latest crash was heavily driven by bad debt and stupid speculation. The idea that houses would appreciate by 6% indefinitely, a claim I heard from an analyst on Wall Street, was stupid. No item should be expected to appreciate indefinitely in excess of the cost of producing it. The logical conclusion would have to be that earnings in home construction would also grow dramatically and indefinitely without attracting competition.
In both cases, we can point back to the issues that created the crash, though obviously the market as a whole failed to foresee them. The threats to the current market appear substantially weaker, but there are still significant threats. The largest should be the growth rate in GDP:
It doesn't take a great eye to determine that the growth rate in real GDP is declining rather than increasing. This decline in the growth rate of GDP comes despite record levels of "education" (sorry, most degrees aren't worth the frame they put it in). This comes despite young people taking on substantially higher levels of debt. The decline persists despite incredible advances in technology. The decline persists despite extremely accommodative policies from the Federal Reserve. The decline persists despite record low 10 year treasury yields. Put simply, the decline persists.
The ten year rates since 1962 are demonstrated below:
Clearly the cost of debt is exceptionally low, but this has failed to fix GDP growth.
The simple connection is that GDP growth is weak as corporate investments lag to permit more cash to be sent back to shareholders. While buybacks in isolation are not an economic problem, the wide spread use of buybacks at the cost of increasing productivity capacity creates a handicap for economic growth.
While economists were widely supportive of accommodative policy, the expectation was that cheap debt would lead to expanding productivity capacity and accelerate investments in new technology. If they knew that the cash would simply be used to fund buybacks and higher dividends, I don't believe there would have been such widespread support.
The Cobb-Douglas function finds GDP growth rate as a function of the increase in TFP (total factor productivity), growth in labor hours (adjusted for elasticity) and growth in capital (adjusted for elasticity). The expectation was that low rates would encourage growth in capital assets. Stocks and bonds are financial assets, a capital asset is usually a physical item that can be used to create or deliver other goods or services to customers. For instance, a factory is a capital asset.
One of the major threats to the market over the long term is the weak growth rate in GDP. Unless earnings climb further as a percentage of GDP, the potential growth for corporate profits is severely limited by the lack of GDP growth. To create that GDP growth requires capital expenditures in new productive assets.
Further quantitative easing under traditional measures would be pointless. Lowering the long yield on treasuries is clearly not incentivizing investment in productive assets. However, it could further cheapen debt so that companies could repurchase more of their own stock and it could suppress bond yields to push more income investors into buying equity for the dividend yield. In that manner, it could push stock prices higher, but that shouldn't be confused with success.
Yes, unemployment is at much lower levels. However, it is worth noting that the percentage of the population counted as part of the labor force declined significantly and a growing number of people are employed in low-wage and low-skill positions. These positions are glorified for reducing unemployment, but due far less to grow GDP because they represent a low-value use of labor hours. Remember that the Cobb-Douglas function looks at the total labor hours as one of the inputs. Without investments in R&D or capital expenditures creating new jobs and new fields, there is little reason to expect a dramatic improvement in the productivity achieved through these labor hours.
Neither share buybacks nor the creation of low-wage positions is going to restore the GDP growth rate. More quantitative easing could be used to weaken the dollar, but it is unlikely to fix the weak growth rate in real GDP.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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