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Stock buybacks a warning signal

Jan 5, 2014 @ 12:01 am

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Companies in the U.S. have been criticized for using corporate money to repurchase shares rather than for growth by investing in research and development.

In fact, share repurchases in 2013 topped $750 billion as the year ended, and some of that was borrowed money. Companies have also paid out significant amounts in -dividends.

This pattern could be a warning signal to investors that corporate management has little faith that the economy will reward investment in projects that will expand companies, or that management has run out of ideas for corporate growth. Either would be bad for investors. The last time companies paid out so much to buy back stock was 2007, immediately before the financial crisis.

Several factors influence corporate decisions to invest in share buybacks rather than in innovation and expansion. In some companies, it's likely that all of the factors are at work at once.

EARNINGS PER SHARE

Sometimes management is feathering its own nest with buybacks because the strategy reduces the number of shares outstanding and thus increases earnings per share. Many incentive pay packages for top executives are tied to increasing earnings per share. Unfortunately, increasing earnings per share in this way may fool the unwary investor into believing that the company is growing when it is not.

In other cases, corporate management may truly be concerned about the slow growth in the economy, as well as the lack of final demand for products, and decide to return some of the cash to shareholders, who might be able to reinvest it for better returns rather than hold it hostage.

The possibility that management at so many companies might have returned cash to investors because they had run out of ideas for investment in the companies' industries is of particular concern because it suggests slow growth in the economy in the months and years ahead.

Whatever the reason, the high level of share repurchases is a warning signal that all may not be well in corporate America despite the record-setting stock market rally. It might be a false alarm, but investors and their advisers should pay attention just in case.

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