What's Behind the Buyback Binge?

It seems that today some of the biggest buyers of stocks in the United States are the corporations that issued them in the first place. Stock repurchases, or buybacks as they are called, have gained an impressive momentum during the past year. The trend reveals two things about the judgment of the corporate executives: First, they must think that the stocks are a good buy. Otherwise, they would be issuing new shares, not buying them back. Second, it implies that corporate executives see little alternative opportunity to use their funds, say, for hiring or upgrading their physical facilities. Since little is likely to change such attitudes, the buyback trend and, incidentally, the go-slow economy will both likely persist.

The pace of stock repurchases is certainly impressive. An official government tally is not yet available, but private sources suggest that American corporations in the year through September 2012 repurchased some $275 billion of their own shares.1 If that pace held through the fourth quarter, the purchases for the whole year would come to almost one-third of a trillion dollars, or almost 1.5% of the outstanding value of all U.S. stocks at the start of 2012. Several firms have taken even larger proportions of their shares off the market, while other prominent players, International Business Machines (IBM) and United Technologies among them, have announced multiyear buyback plans in the billions of dollars each.

Certainly nonfinancial corporations in this country have the wherewithal to support such purchases. According to the Federal Reserve, these companies have a cash hoard near $1.5 trillion. Their bank deposits alone amount to a whopping 10% of their current liabilities. With such cash-like investments paying rates of 30 basis points or less, financial officers hardly have an incentive to leave the assets where they are. In the meantime, long-term borrowing rates for most companies are so low that most established, dividend-paying companies in the S&P 500® Index2 pay higher dividend yields on their stocks than they do on their own bonds. They can, then, save by borrowing to buy back shares.

Nor is it just that borrowing rates are low; stocks, in our view, clearly are a good buy at today's prices. Price-to-earnings multiples,3 even after the market's gains of the past year and even on historical earnings, are low compared with long-term averages. More, stock values relative to bonds, Treasuries, or high-grade corporates, remain at historically attractive levels. The comparison of dividend yields to borrowing rates (noted above) gets to this relationship. Though such comparisons always leave open the question about which asset class is mispriced, corporate managers have made their judgment clear. They are selling bonds to buy stocks.

Meanwhile, slow growth globally and high levels of policy uncertainty have made executives cautious about expansion. After three and a half years of recovery, business still employs 4.1 million fewer workers than in early 2008. Overall spending by companies on new equipment and facilities, which began the year remarkably strong, has begun to slide. Orders for new capital goods through November 2012 (the most recent period for which data are available) show this reluctance as well.

None of these considerations seems likely to change anytime soon, certainly not very quickly. Even after all the repurchases, corporations still have huge cash hoards. Borrowing rates will likely remain low as well: the Fed has promised this. While both circumstances will continue to make repurchases cheap and easy, corporate executives will continue to be little tempted by alternative uses of the funds. Policy uncertainties will remain a cautionary for any corporate expansion plan. The "solution" to the so-called "fiscal cliff" leaves much unanswered, while the implementation of the Patient Protection and Affordable Care Act will keep managers unsure of the cost of new hires. The outlook in Europe, too, will remain vague, and though China seems to have stabilized, questions will remain about sustainable growth in emerging economies in general. These are only three of the more prominent unanswered questions facing corporate decision makers. Meanwhile, corporations, by slowing the pace of hiring and capital spending, will reinforce their own caution by keeping domestic economic growth slow. Repurchases will still look like a best use of their surplus funds.

1 Data from Yardini Research.

2 Data from Standard & Poor's. The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

3 The price-to-earnings [P/E] ratio is an equity valuation measure defined as market price per share divided by annual earnings per share.

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