If you’re wondering why the economy remains stuck in second gear, consider this hypothesis:
Instead of investing in new plants, equipment and products, instead of paying their taxes and giving a long-overdue raise to their employees, big corporations are spending their record profits — plus gobs of newly borrowed money — to buy back their own shares and those of other companies.
The latest data from Dealogic shows that U.S. companies have announced more than half a trillion dollars in mergers and acquisitions this year, 34 percent ahead of last year’s brisk pace. Chief executives in the tech, telecom and pharmaceutical industries apparently can’t look themselves in the mirror these days if they don’t have some industry-altering deal in the works. Wall Street investment bankers are predicting a banner year for fees and bonuses.
In the short term, of course, all this dealmaking has the effect of lifting the entire stock market as every company rushes to get in on the action and every company becomes a potential acquisition target. But over the long term, studies show that mergers and acquisitions destroy shareholder value, particularly those done when stock prices are at or near their peak, as they are now.
Meanwhile, the corporations of the Standard & Poor’s 500-stock index spent $477 billion last year buying back their own shares, a 29 percent increase over 2012 and the most since the peak year of 2007. The idea behind buybacks is that they are a tax-advantaged way to return profits to shareholders by boosting the market price of their shares. Since the stock market tends to value companies by multiplying the profits per share times the number of shares, reducing the number of outstanding shares has the arithmetic effect of boosting the stock price.
Buying back shares is so in vogue that 80 percent of the S&P 500 did it over the past year, according to Kiplinger. Among the more aggressive have been Boeing, Caterpillar, Cisco, 3M, Microsoft, Safeway and Travelers, who all bought back more than 10 percent of their shares, reports Zero Hedge, the widely followed investor Web site. Apple alone has announced it would spend $130 billion to repurchase shares. Last week, Ford joined the parade with an $18 billion buyback.
And make no mistake: In the short term, the buyback strategy works. Stock buybacks in the S&P 500 transformed what would have been an 80 percent rebound from the lows of 2009 into a 178 percent increase, according to a study by Fortuna Advisors.
It would be one thing if most of these stock buybacks were paid for out of the trillions of dollars in cash now sitting on corporate balance sheets. But as it happens, most of them have been paid for by near-record levels of corporate borrowing. Of the $3.4 trillion in additional debt taken on by nonfinancial corporations since 2009, nearly 87 percent has been sent off to shareholders in the form of dividends and stock buybacks, according to Paradarch Advisors.
The poster child of the corporate sector for this leveraged buyout is IBM, which in the first quarter bought back more than $8 billion of its own stock, almost all of it paid for by borrowing. By reducing the number of outstanding shares, IBM has been able to maintain its earnings per share and prop up its stock price even as sales and operating profits fall.
The result: What was once the bluest of blue-chip companies now has a debt-to-equity ratio that is the highest in its history. As Zero Hedge put it, IBM has embarked on a strategy to “postpone the day of income statement reckoning by unleashing record amounts of debt on what was once upon a time a pristine balance sheet.”
More significantly, IBM since 2102 has invested four times as much in stock buybacks as it has on the capital expenditures needed to grow its business over the long term.
And in that it is not alone. Last year, the companies of the S&P 500 spent 30 percent more on stock buybacks and dividends than on capital expenditures. It’s simply the latest proof that in the boardrooms and executive suites of corporate America, financial engineering has long since overtaken the more productive kind.
One reason companies are gorging on share buybacks is that it inoculates them from the unwanted attention of “activist investors” who swoop in and demand them, hoping to make a quick score. But other investors are skeptical.
In March, Larry Fink, chairman of BlackRock, which manages $4.3 trillion of other people’s money, wrote the chief executives of 800 of the world’s largest corporations to tell them of his concern that they were investing too little in future growth.
“Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks,” wrote Fink, adding that when done for the wrong reason, such tactics “jeopardize a company’s ability to generate sustainable long-term returns.” About a dozen executives wrote back privately to praise Fink, but the public response to the widely reported letter was akin to a deafening silence.
One “wrong” reason for doing buybacks would be to benefit top executives whose incentive pay is pegged to the share price or earnings per share. That’s surely going on, but it’s even worse than that, as Nejat Seyhun, a finance professor at the University of Michigan, has discovered.
Seyhun calculates an index of bullish or bearish sentiment among corporate insiders based on whether they are buying or selling more of their company’s stock. And over the years, he’s noticed a pattern: When companies are most aggressive in buying back their stock on the open market with shareholders’ money, company insiders are most aggressive in selling shares from their own portfolios.
Seyhun and a colleague are now trying to calculate this correlation over time. But what he can report is that his gauge of insider sentiment is now more “bearish” than at any time in the past 25 years, after falling steadily for more than two years.
Self-dealing by corporate insiders, however, is only part of this story. The Federal Reserve has also played a big role in the buyout bonanza. Over the past five years, the Fed has pumped $3 trillion into the financial system, much of which remained there rather than making its way into the real economy. That’s made it easy for companies to use cheap borrowed money to buy back their stock, or that of other companies.
At a more fundamental level, however, the buyback and merger mania is driven by the siren call to “maximize shareholder value” that now dominates corporate decision-making. It is the rationale for stock buybacks, dividend increases and all the me-too mergers. It explains the lackluster pace of capital investment and the refusal to share record profits with front-line employees who haven’t had a raise in years. And it drives the fetish for tax avoidance that now, in the minds of executives, “requires” companies to move headquarters to low-tax jurisdictions and “requires” them to keep trillions of dollars in untaxed profits overseas.
What’s missing from the current recovery, in short, is all the money that corporate America has frittered away on financial game-playing — money that could have been used to invest in equipment and products, to put extra money in the pockets of consumers, to provide the tax money government needs to invest in basic infrastructure and research and the education of the next generation of workers. A trillion here, a trillion there, and pretty soon you’re talking about real money.
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