Stock Buybacks - A Red Flag?

As we move from one year into the next, it is a good time to step back and reflect on patterns emerging in various areas of the business landscape. One pattern that I find disturbing is the growth of stock buyback activity.

Barry Ritholtz recently drew attention to this in his posting on “An Unprecedented Mass of Buybacks” at his blog The Big Picture. Some other articles on this topic have appeared in Barron's (subscription  required) and the Wall Street Journal (purchase required). In his blog, Barry indicates that the S&P 500 companies bought back $456 billion worth of stock last year.  That’s almost one-half trillion dollars!

When you add in dividends (the other major form of payment to shareholders), the S&P 500 increased their payments to shareholders by 30% over another record year of payments in 2004. What’s going on here?

Now, there are many explanations for why this is happening, some more benign than others.  At one level, this outflow of cash to shareholders is refreshing.  There are strong institutional incentives for managers to hold on to any cash they generate.  Too often, senior management will re-invest this cash in low return business ventures rather than return it to shareholders. Classic finance says that if managers can’t find investment opportunities above the cost of capital, they should return cash to shareholders and let them find more attractive investment vehicles.

And yet, there’s another explanation that causes more concern.  Most large American companies for years have been pursuing aggressive cost-reduction strategies, especially in the aftermath of the 2001 recession.  They have generally been very successful at cutting costs and substantially increasing cash flow generated from operations. But then the question becomes, what to do with the cash? Companies with a high rate of innovation generally have no problem in answering this question – they use the cash to fund the next wave of innovation initiatives.

But, companies with low innovation capacities run into a real problem.  The accumulation of cash becomes an embarrassment and they start paying it out.  So, one way to interpret the surge in dividend and buyback activity is that it reflects a fundamental imbalance in management focus: aggressive cost-cutting initiatives combined with low innovation capabilities.

This is a real danger signal in a global economy with intensifying competition.  In this environment, cost savings are generally not sustainable – they rapidly get competed away and captured by the customer.  Unless companies have the innovation capacity to redeploy these savings rapidly into productive new business initiatives, they will end up shrinking.

Now, many managers will reply that this is unfair.  In fact, one of the often cited reasons for share buybacks is management’s belief that the public capital markets have undervalued their stock. If this is the case, buying the company’s own stock may in fact be one of the best investments available – when public investors finally come to their senses and realize the true value of the company’s stock, the stock repurchases will earn a healthy return on investment.

While this may be true in some isolated cases, there’s something that just doesn’t ring true.  There’s growing liquidity in capital markets around the world.  Investors are competing with each other to find attractive investment vehicles.  Can it really be the case that there are so many instances of undervalued stock among the S&P 500 to justify such widespread and massive buyback activity?  Maybe investors are appropriately skeptical about the innovation capacity of these companies and discounting management’s rosy projections about sustainable profitability and growth potential.

For those who are interested in understanding recent trends in share repurchases and their financial consequences, Michael Mauboussin, the Chief Investment Strategist at Legg Mason Capital Management, has recently released a great report on “Clear Thinking about Share Repurchase".

What’s the bottom line here?  Simple – a growing number of US companies have reached a point where short-term cash generation exceeds their innovation capacity.  In the short-term, they are doing the right thing – giving cash back to shareholders and relying on them to find more attractive places to invest their funds.  But in the long-term, this is a formula for shrinking the business.  Senior management teams have got to find ways to unlock the innovation potential that resides in all their companies.  If they don’t, they will find recent cost-savings competed away, cash flows eroding and shareholder value shrinking.

Comments

[Richard Veryard]

Mike's first point cen be generalized to cover any process innovation that is focused on efficiency. But one company's cost reduction may be another company's loss of revenue. So the aggregate effect of local innovation might be global stagnation.

I interpret Mike's second point as suggesting a partial decoupling of the traditional tight coupling between innovation and capital. That is indeed a radical idea, with some perhaps uncomfortable implications.

[Mike nevens]

Let me offer two poential additonal explanations. Managers in many sectors continue to udnerstaimate the prodcutivity benefits they are (finally) gaining from IT investments. The benefits took loner to arrive than hoped and are non linear becaure cahnges across the organization are multiplicative not addative. This applies to capital efficiencies as well as cost reductions. So, the cash flow is greater than projected. Second, many new business innovations are "capital light". Idea driven or intellectual property based innovations don;t require the same level of capital investment as previous innovations. It would be valuable to have osmepone grind throught the numbers and see how much of the "excess returns" to investors are accoutned for by these two effects. These are good not worrying signs for the future of the economy.

[Richard Veryard]

Big companies returning capital to their shareholders? Perhaps this reflects a shifting balance of effective innovation towards smaller companies, and a faster corporate lifecycle. How would an unbundling of investment and innovation look from an Edge perspective?

[Adam Marsh]

Another explanation in a recent BusinessWeek article is that buybacks are just covering for options, and so actually in many cases don't change the outstanding shares much: article here.