An Old School Financial Analyst Rant…

A company can basically do three things with its net after tax income. It can pay dividends. It can reinvest back in the business through plant and equipment spending, research and development expenditures, and the acquisition of other companies. Lastly, it can buy back its shares. Pretty simple.

Spoiler alert, we are not big fans of buybacks. We think that companies should be in the business of growing sales, increasing earnings, reinvesting back in the business and paying dividends. Some companies like Warren Buffett’s Berkshire Hathaway pay no dividend, arguing that they can invest their net income more profitably than shareholders. This is fine; Berkshire has proven it can do it. Buffett also will not buy back shares unless the price falls below a level he sees as ultra cheap relative to assets. It rarely has.

Proponents of regular buybacks argue that it benefits shareholders, increases the stock price and drives up earnings per share (by reducing the share count). Proponents of buybacks also note that dividends are tax inefficient. A company pays taxes on its earnings before paying dividends and then investors pay taxes on the dividends received. But taxes on dividends are not what they used to be. For instance married filers who earn less than $78,000 pay no income tax on qualified dividends (most dividends are qualified). Married filers who earn up to $478,000 pay 15% and the super rich pay only 20%.

The chart at the bottom shows the significant increase in buybacks over the past ten years. Anne wrote last month about companies who buy other companies. They more often than not pay too much or buy companies at the wrong time. The same criticism might be leveled at buybacks. Note that when stocks were cheapest (2009), there were few buybacks. I realize that in 2008 companies had very little earnings and limited excess cash but still the idea is you buy back at the low and you keep your powder dry at the high.

Today, with stock prices much higher than 2008, buybacks are soaring. It’s estimated that companies bought back $770 billion of stock in 2018, and this year Goldman Sachs estimates the number will be $940 billion. This is greater than the subprime mortgage market in 2007. I hope this is not our Bubble du jour? Stephanie Pomboy of the economic research firm MacroMavens argued recently in Barron’s that half of the recovery in the S&P 500 the past 10 years has been fueled by buybacks. If buybacks get cut back dramatically due to a weakening economy…..well I guess we will have to wait and see what effect this has.

One more thing on buybacks. Companies issue a lot of new shares as incentives and bonuses to employees. This is good in that you want a motivated and well paid staff. But many companies go overboard showering senior management with excessive amounts of new shares. Buybacks work to mask this by offsetting the newly issued shares. Companies have to report share bonuses but the numbers are buried deep in the footnotes. Investors beware.

So our advice to companies is – keep things simple, spend liberally to grow your business and pay dividends. Go easy on the buybacks.

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