From time to time we hear about a company repurchasing their common stock. What does this mean and is it a good thing? When a corporation repurchases its common stock, it goes into the stock market, just like an investor would do, and it purchases its own stock with corporate dollars. The stock then comes into the corporation as treasury stock. Corporations do this because they are trying to reduce the shares that are outstanding in the market. This in turn should increase the earnings-per-share which means that each individual shareholder should then expect to see an increase in earnings of the portion of the company they own. That in turn should in theory, cause the stock price to move higher.
Historically, when all is said and done, the massive repurchase of stock by corporations has not panned out well. The reason in part is that companies that do this no longer believe that growing their business is the best use of capital. Thus, they speculate in the markets on their own stock instead of building real wealth in terms of capital improvements and jobs. In short, these corporate stock purchases are an indication that these companies believe that their business capacity is at its limits and/or a threshold has been hit in terms of deriving more economies of scale to improve their operating margins translating into higher profits.
On the short-term, these corporate stock repurchases work for a little while. They help to fuel and extend bull markets. In turn, public optimism and an increase in their paper wealth add fuel to the economy. However, once the business cycle comes around and business declines, so does the market value of their securities. There’s the catch. Remember, long-term bull and bear markets are ultimately dependent upon growing or diminishing economic and business fundamentals, they cannot be sustained simply by companies, institutions and individuals buying or selling stock.
When companies look around and say, “our primary business is such and such widgets and the way to make money now is not by investing in plants, equipment, extension of service or better economies of scale, but rather by investing in the stock market,” it’s is a sure tale sign that overcapacity exists in that economic sector. If this occurs in many industry groups then the economy at a whole is at risk of overcapacity. When business eventually falls off, the compounding of reduced business and a falling stock price adds a kicker to both the company’s woes and the markets. Just consult the history books regarding the market declines of 1907, 1929, 1937, 1973-74, 1981-82, 2000-2003 and 2007-2009. Just like borrowed money, corporations buying their stock works well on the way up. It doesn’t work so well on the way down.
According author and financier Peter Cohan, “many professional money mangers and investors interpret stock buybacks as a sign that company CEO aren’t doing their most important job—finding sources of new growth. If the best idea they can come up with is to funnel money back to shareholders, those company boards should replace the CEOs with people who have better ideas.”
“Primarily, stock buybacks are a shell game designed to boost CEO pay. Analysts look at the stock buybacks and realize immediately that they will reduce the number of shares outstanding, thus artificially boosting earnings per share. Since many CEOs get bonuses based on Earnings Per Share increases, by giving money to the shareholders, they indirectly pave the way to higher bonuses for themselves.”
Quote of the Week: “One machine can do the work of fifty ordinary men [women]. No machine can do the work of one extraordinary man [woman].”—Elbert Hubbard
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.