The Reason Buybacks Will Hurt America

After reading this blurb in Investors Business Daily, I was inspired to share my two cents on the subject:

Flush with cash after a string of fat profits, S&P 500 firms bought back $116.7 bil of their own stock in Q2, says Standard & Poor’s. That’s a 43% surge over a year ago and 175% more activity than seen 2 years ago.

The Reason Buybacks Will Hurt America

Our countries largest corporations have enormous share buyback programs in place. These buybacks have the potential to stifle economic growth, business development, and our country’s entrepreneurial spirit.

I believe there is a common misconception about buybacks that plagues our society. We have been taught that a company will buy back its stock when it is sufficiently undervalued. Maybe that is true, maybe companies know enough about the stock market to time their purchases in order to invest in their future and generate returns as their stock goes higher. Unfortunately, I do not fall into this camp.

Contrary to the popular Wall St. belief, I feel that buybacks are bad for companies and more importantly bad for America. There is an opportunity cost associated with stock buybacks in the form of a trade off between business investment and equity investment. If a company spends billions buying back stock; that means it avoids spending billions on new business ventures. This leaves corporations vulnerable to the possibility that some company without a shortsighted “EPS view” of the world will create something truly unique. This, in turn, has to potential to supplant our nation’s corporations as worldwide powerhouses because they failed to focus on the future. Instead they wanted to please Wall St. today.

One of the main drivers behind the shortsighted behavior of companies today is the nature of Wall St. Companies need to make their quarterly numbers. If they don’t, their stock will (more often than not) go down. To make numbers, companies are often forced to slash their R&D budgets and cut back on taking chances. They attempt to streamline operations and avoid jeopardizing quarterly numbers. This is bad for our future as Americans. This is bad for the long term health and prosperity of these corporations.

Complicating this issues is the use buybacks as a form of earnings per share (EPS) management. Often times, when Wall St. analysts model a companies EPS, they are grossly inaccurate at determining the shares outstanding for the quarter. What happens is a company has 20 million shares outstanding and it announces a buyback. When a company notices conditions are starting to deteriorate and that they might miss expectations with 20 million shares outstanding, they opportunistically purchase 1 million shares. This transforms the quarterly headlines into “XYZ beats EPS by $0.01-shares rise” instead of “XYZ misses by a penny - shares plunge.” Unfortunately, this is the game companies are forced to play.

Taken a step further, I view buy backs as a sign of a deteriorating business environment. Instead of acquiring a small distributor, a company buys back 500,000 shares. Instead of investing in fuel efficient vehicles, a company shrinks its float by 2%. How does this benefit the investor? Maybe it limits some of the downside, but as an investor I prefer upside relative to limited downside. Simplistically, the best way to achieve that upside is by inventing a new product that people actually buy. The best investments in the world were not created because a company bought back its stock. They were based on ideas, innovation, and entrepreneurial spirit that in the end translated into sales.

Microsoft performed best from 1985 – 2000 when it worked to create the operating system that nearly ever computer in the world uses. Now the company has turned to buybacks to generate interest in its shares and has pushed it stock up with its most recent buyback announcement. However, I ask you to question which move was more meaningful; the multiple thousand percent increase MSFT had from its IPO date, or the 15% pop it got from a buyback. Maybe if MSFT had spent some of that money investing in people, technology, and research, Vista wouldn’t have been delayed as many times as it has. Gains generated from buybacks do not last. A buyback is simply a form of throwing in the towel without letting Wall St. know.

I could not imagine what the world would be like if companies took the initiative to invest for the future. Take Exxon Mobile for example. Year to date, XOM has generated $25 billion in operating cash flow, paid out nearly $4 billion in dividends, and repurchased $12 billion worth of shares. I am not expert in this field, but I would imagine that with $12 billion, some sort of advancement in alternative energy could be produced. Better yet, from XOM’s perspective, if the new technology they produce is viable and effective, sales and profits will invariably follow. However, our society rewards them for not taking chances. It is tough proposition for a company to take on because if the idea fails, the stock will be relentlessly punished. This sort of thinking is bad for America.

If record setting buybacks continue, down the road America will be faced with some very dire consequences. Our country was built on new ideas. We need to rejuvenate that spirit and encourage our corporations to innovate, take chances, and help build a better America.

I hope this article at the very least encourages people to think about why companies may buyback stock and avoid the common groupthink response, buyback = good. I welcome any feedback @ randommarketthoughts@gmail.com