Corporations basically have one job to do: They have to act in their shareholders’ best interests.
Unfortunately, that isn’t happening, at least not for the vast majority of shareholders. Namely, all the ones that aren’t in C-suites and don’t have bonuses that hand over tons of shares.
Share buybacks are projected to hit an unprecedented $450 billion this year, and February already saw $98 billion announced:
For the last several years, the market has been trained to eat this up. Like Pavlov’s dogs, ringing the buyback bell gets investors salivating and bidding up share prices.
The thing is, it won’t keep working. Some early signs point to how this trend will fall apart this year, forcing investors to take some large losses.
When this happens, the right way to return corporate cash to shareholders will become dominant once again.
Ill-Conceived, Ill-Fated
At the most basic level, large share buybacks are a form of incompetence.
The people who are in charge of making the business better — and are paid hefty sums for it — essentially give up on doing their jobs and spend corporate cash on the illusion of improvement.
The Great Recession and Fed policies since have skewed that even further though. Instead of being unable to find a worthy use for profits, management now has a short-term, self-serving incentive to take out low-cost debt to repurchase shares.
This is a huge disservice to shareholders, and IBM is a great example of how this pans out.
Since 2000, IBM has poured $108 billion into share buybacks and $30 billion into dividends. Over the same period of time, it spent just $59 billion on capital expenditures and $32 billion on acquisitions.
This has come at a severe cost. IBM’s revenue is about the same as it was in 2008, and debt has ballooned to $40 billion.
This debt and lack of capex has added up. Missed quarterly expectations late last year led IBM share prices down to a level it first crossed in 2011.
That means IBM ultimately paid a hefty premium for all of the shares bought over the last four years. From the share price peak in mid-March 2013, shares have fallen about 23.5%.
Shareholders were fine with this while prices were going up. Buybacks remove shares from the market, driving up earnings per share figures and generally making most superficial metrics look better.
Yet, in the end, management at IBM hasn’t found a way to improve the company in seven years. The buybacks wasted limited time and resources, and ultimately billions in company profits disappeared as IBM shares lost value.
More To Come
Unfortunately, IBM isn’t an anomaly. Itt is the canary in the coal mine.
The earnings-per-share ratio average for the market, in no small part boosted by buybacks, is up to 18.
A more obscure, but potentially more useful, metric is way up there too. The average enterprise value (EV) compared to earnings before interest, tax, depreciation, and amortization (EBITDA) is up to 11.
To see how that compares, check out this chart from researchers at Goldman Sachs:
As Goldman Sach’s chief strategist David Kostin noted, “These valuations rank in the 99th percentile of both P/E and EV/EBITDA multiples since 1976,” and, “The only time during the past 40 years that the index traded at a higher multiple was during the 1997-2000 Tech Bubble.”
With the market boosted to all-time highs, the $450 billion of expected buybacks are offsetting larger net outflows from households and pension funds:
Add in a couple extra factors and it doesn’t paint a pretty picture:
- 2015 revenue projections dropped from 10.3% at the end of 2014 down to 2.8% a couple weeks ago.
- EPS growth fell two-thirds from 8.2% to 2.8% (with the boost from buybacks).
- Rolling over debt in the next couple years will be more expensive with interest rate jumps.
- Capex growth has been pathetic, and will decelerate further:
IBM isn’t going to be alone in paying for shares at all-time highs, only to be punished for not adequately investing in the future of the company.
It won’t be alone in paying a hefty premium for shares at all-time highs, only to see cash that could have increased earnings disappear as investors abandon ship and share prices fall.
The Right Way To Do It
To actually return cash and generate value for investors, corporations need to use a time-tested and proven method.
Dividends are far superior to buybacks across the board.
First off, dividends can only be paid from earnings, not from debt. The advantages here in a low-growth economic climate are pretty obvious.
Buybacks aren’t any good at attracting long-term investors. Chasing buybacks can be profitable, but the IBM example shows how quickly that can and will backfire.
Plus, taking short-term gains means taking a large tax hit, especially compared to holding shares for at least a year and qualifying for the long-term capital gains tax instead.
Dividends also allow shareholders to choose how to use the money that is returned to them. Individual shareholders can opt to reinvest or take a cash payment.
Buybacks, in this sense, are a form of forced reinvestment. One that directly benefits corporate insiders as it helps them improve EPS, qualify for bigger bonuses, and drive up the shares given to them as part of that bonus.
Finally, dividends promote stable and lucrative long-term business strategies. They compel management to focus on increasing earnings and cash flow, thus making the company stronger.
Act Before It Is Too Late
Before the end of the year, we will see the dominance of buybacks erode. Share buybacks surpassed dividend payments in the S&P 500 back in 2013, but I expect this to be an aberration.
The pace of buybacks is completely unsustainable, along with the low level of capital expenditures that come with it.
More and more companies will miss earnings targets, and investors will be pulling out of companies that fuel buybacks with debt.
Hopefully, many of these investors will remember that there is plenty of cash being returned to shareholders that doesn’t involve cannibalizing a company for a short-term share price boost.
There is no way around the fact that some investors will be burned, but acting now will front-run the risks and greater inflows to dividend stocks.
There are plenty of stable companies out there that will be immune to the decline of share buybacks, and a handful of them offer incredible yields with very low risk.
One such company is going to be returning 30% of the current share price in 2015 alone.
Time is of the essence though. To capture the full 30%, investors only have a couple weeks to act, and the next round of earnings aren’t far off either.
Log in or sign up for Jimmy Megnel’s Crow’s Nest publication for full details on that opportunity.
