Over the past several years there has been an increase in the repurchase of common stock by American corporations. Historically, when all is said and done, the massive repurchase of stock by corporations has not panned out well. The simple reason: companies 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 its industry capacity is at its limits and/or a threshold has been hit in terms of deriving more economies of scale.
On the short-term, these widespread and large 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 securities. There’s the catch. Remember, long-term bull and bear markets are ultimately dependent on 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 companies woes and the markets — consult the history books regarding the market declines of 1907, 1929, 1937, 1973-74, 1981-82 and the dotcom bust earlier in this century. Just like borrowed money, corporations buying their stock works well on the way up. It doesn’t work so well on the way down.
Additionally, CEO’s often like to have stock buybacks because it increases what is known as earnings per share. The earnings per share of common stock is obtained by dividing the net income by the number of outstanding shares of common stock, after deducting the preferred dividends. The reason that CEO’s like these buybacks is because their pay is often based on earnings per share. In short, buy back the stock with company’s money and increase the salary and/or bonus of the chief in charge.
In short, as a shareholder, beware of stock buybacks.
Quote of the Week: “One machine can do the work of 50 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 adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.