There has been plenty of discussion regarding Larry Fink's recent comments among investors everywhere, much of it very negative towards his comments. This article is meant to broaden the arguments of his letter, and hopefully cast it in a light that shareholders can better understand where his thoughts come from.
For those not aware, Larry Fink is the CEO of BlackRock (NYSE:BLK), and recently mailed letters to the largest names in business, urging them to use caution in regards to their returns to shareholders. The message was clear: Stop focusing so much on dividends and share buybacks as a method of deploying cash, and instead, focus on their core business. Larry Fink believes these means of capital return can be value-destroying; a flashing beacon that shows a company is unable to create long-term value with its retained earnings.
I agree with Larry Fink here, but investors need to be clear that both of us aren't against dividends and buybacks in all cases. For those long-standing companies with mature business models and a lack of reasonable outlets of growth, cash returns such as dividend payments make sense as a way of returning excess cash to company stakeholders they are due for their partial ownership. As an example, mature regulated utilities would fit into this mold, as would REITs in that they are mandated to make these returns.
We have, however, gotten to a point where buybacks and dividend increases have grown increasingly common simply as a means to give immediate strength and momentum behind a stock in the short term, especially as market sentiment has turned. Investors need to keep in mind that whenever a company is spending its cash reserves on share repurchases and dividends, a company is telling you that it has no better method of investment that would generate a higher rate of return. Investment decisions are simple: if you have available funds, it only makes sense to choose the project(s) that have the highest expected return for your business. So when a company such as General Electric (NYSE:GE) announces that it is repurchasing $50B of shares, it is telling you by way of its actions that the company believes share repurchases will provide a better value than:
- Accretive acquisitions that would give the company expanded reach in its existing markets, or give it access to new ones.
- Investing in the business through capital expenditures, allowing the company to gain returns through research and development, infrastructure and technology upgrades, or hiring and retaining top talent.
- Holding cash in the short term so that capital is available when the above options become more attractive, or allowing the company reserves to weather future weakness in their markets.
So as the market sits at all-time highs and trades at historically high valuations on nearly every measure, corporations continue to make the statement that the above would generate lower returns than investment, so buybacks are also at all-time highs. While some companies' shares may certainly be undervalued even in this market, chances are the market is going to make a fool out of plenty of top-level management in the coming years. It is a timeless piece of investor thought that who best to know a company's value than management. Makes sense in theory, but management isn't always right, and repurchases can be destroyers of value. There are numerous historical examples of companies like Ocwen (NYSE:OCN), which authorized a $500M share repurchase plan in late 2013, when shares traded at nearly $60/share. Ocwen sure could use that money now as shares trade at less than $8/share and the company battles legal problems and intense regulatory scrutiny.
Investors should keep in mind that we operate in a world where more and more of top executive pay is rewarded through stock options. Options are often awarded through hitting stock price and earnings per share targets, which can create perverse short-term incentives where share repurchases and dividends allow management with high stock ownership to pad their own pockets. The Board of Directors wants management to grow EPS at 7% a year? Buy back 4% of the float each year, and you are more than halfway there. A little inflation that raises the price of your goods/services, and job well done. And if you're short on cash to do that buyback? Just borrow some - a little leverage never hurts.
And yes, we all know corporate coffers are chock-full of available funds. Sitting at all-time highs, companies are busting at the seams with $2 trillion worth of available funds. But the majority of these funds are held overseas, as companies are unwilling to repatriate this cash to avoid U.S. taxes. Companies are, in fact, raising debt here in the U.S. to fund buybacks and dividends, when they have the equivalent amount sitting in non-U.S. domiciled bank accounts - a twist that may have its own repercussions down the line. Politicians are more unwilling to touch the repatriation tax because the prior results from the 2004 holiday - originally thought of as a way to boost research and development and put more Americans to work on the back of hundreds of billions of new funds available for spending - just ended up being a share buyback party for companies like Pfizer (NYSE:PFE).
The theme here is not to always view capital return to shareholders as a good thing in all cases. Investors always like what can be perceived as easy money, and it can be difficult to objectively view these types of shareholder returns. So the next time one of your holdings announces an increase, take a careful look at what that return means for the company's health long-term. Is the company's debt manageable and financed at low rates? Is the company free cash flow-positive? Does it have funds available for a rainy day if the markets it operates in turn sour? What incentives does management have? These are all important questions to ask to keep a solid grasp on your holdings and to be able to spot problems.
Disclosure: The author is long OCN.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.