The buyback monster
HISTORICALLY, when stocks are high, corporations sell stock to the public. Its the old When the ducks quack, feed em syndrome. But last year and in 1995, amidst a roaring bull market, American businesses bought back more shares than they sold to the public (see tables, p.136). In fact, corporations have been heavy buyers of their own shares through most of this bull market.
Will buybacks repair the damage after the 1997 selloff? IBM has already thrown another $3.5 billion into its buyback hopper. If the 1987 precedent holds and the market stays down, there will be many more such announcements: In the quarter after October 1987, there were 777 announcements of new or increased buybacks by U.S. companies, according to a study by Rice University Professor David Ikenberry. Size of the pot: $45 billion. Such buybacks certainly helped the subsequent recovery.
These buybacks dont just enhance individual stocks. By reducing the overall supply of equities they put upward pressure on all prices.
Indeed, 24 of the 30 stocks in the Dow Jones industrial average have announced buybacks since 1995.
There were signs before the recent drop that buybacks were slowing.
Through the first three quarters of this year there were 980 announcements of $130 billion, according to Securities Data Co. Actual buybacks, compiled by S&Ps Compustat, however, were only $72 billion, which was exceeded by new stock issues of $92 billion. So after two years in which buybacks exceeded new offerings, the balance had swung the other way.
With the recent drop, however, the pace of buybacks could increase.
A bigger question remains: Do all these buybacks make sense?
Buybacks are certainly tax-efficient. When a company pays a cash dividend, the tax collector hits the income stream twice -- once when the company earns it, again when the stockholders get it. That means a big company must earn $3 to put $1 in aftertax income into a high-bracket shareholders pocket. If the money is used to buy back shares, the remaining shareholders are rewarded with a proportionately higher ownership interest -- and this kind of dividend is taxed only when the company earns it.
Buybacks serve other useful purposes. They help counteract the dilution that results from generous stock option plans and from acquisitions paid for in stock. And they provide support for the stock price at a time when investors everywhere are sensitive to relative market performance.
But there are also negatives. Should a company support its own stock?
And doesnt management have anything better to do with the money?
In the early 1980s IBM began a big buyback program. Between 1985 and 1990 it bought back nearly 50 million shares, shrinking its common capitalization by 8%. The buybacks ended with the collapse of IBMs stock in 1991. Before the decline was over, IBM was down 75% from its high.
Why, at a time of huge expansion of the computer industry, didnt IBM have better uses for its cash? As it turned out, the aggressive buyback program was a sign of weakness for those who cared to read the signs.
Yet today, when IBM lags in the crucial PC business, it is again buying back gobs of its own stock.
In 1987 and 1989, when its stock was often selling at three times its present level, Digital Equipment Corp. was actively buying in its shares. Had management waited, it could have bought three times as much stock for the same price.
Buyback advocates can point to huge successes. Capital Cities Communications bought back aggressively during the 1970s bear market.
From 1972 to 1976 Teledyne Chairman Henry Singleton bought back about two-thirds of his company during a sick market: When the market recovered, Teledyne took off, climbing from $9 to $70 between 1975 and 1977. But mark this: These buybacks were made in a bear market when few had the guts to invest in their own companies.
Coca-Cola, Philip Morris and McDonalds are recent examples of companies with consistent large buyback policies. They have been great long-term investments. In Cokes case, its repurchases of 1 billion shares from 1984 to 1996 were enough to boost annual earnings-per-share growth to 18%, versus a 14% increase in its net income. But neither Coke nor Philip Morris is in a capital-intensive industry; stock buybacks are a legitimate way for them to use free cash flow.
Many institutions push us to buy back stock, says Kurt Landgraf, DuPont chief financial officer, especially since we have a strong balance sheet with $2 billion in cash. My view is that buybacks are the last alternative. DuPont has done buybacks for specific purposes: When Seagrams big block of DuPont stock was available, the company grabbed it, at a bargain price. Later it used buybacks to reduce the diluting effect of a 20% investment in Pioneer Hi-Bred.
But whats good for some companies isnt necessarily good for all.
Should McDonalds be supporting its price with big open-market purchases while its basic business is lagging?
Or take HFS, the high-flying franchise company. A year ago, after saying it would buy corporate relocation company PHH Corp. for $1.8 billion in stock, its shares dropped 25%. HFS responded by buying back more than 2.5 million shares to prop up its price so it could complete the deal. HFS was buying back at over 50 times earnings. Was that good for its shareholders? HFS sells for less than it did before the PHH acquisition was announced.
Theres no question the fad has gotten out of hand. We have never had a stock market trade at such a high value relative to replacement cost [of assets], says Richard Howard, portfolio manager for T. Rowe Prices Capital Appreciation Fund. [In the circumstances] it is extremely unlikely that stock repurchases will do anything to add shareholder value.
They can, however, make managements look good for a while. Consider ailing Storage Technology. In October the Louisville, Colo.-based data storage outfit was attacked by one of its large shareholders, who told management, in effect: Buy back $1 billion of stock, or well throw you out.
The shareholders are former Mesa L.P. managers David Batchelder and Ralph Whitworth. Newcomers to the stock, they are not interested in managements strategic plan to improve operations. They want quick action. That annoys longtime shareholder Seymour Licht, who got into Storage a decade ago as a creditor in its bankruptcy. I didnt hold on to this investment for management to prove its stock-buying expertise. I invested for the memory business, he says.
Batchelder and Whitworth proposed Storage borrow some money to buy back the stock. Management quickly gave in and announced an $800 million buyback. But should a marginal company thats in a tough industry be accumulating debt unnecessarily?
They of course were simply parroting Wall Street, which loves buybacks. The banking industry has also embraced them. According to Salomon Brothers, banks internal rate of return on buybacks has dropped from 44% to about 19%. Some banks like CoreStates Financial, SunTrust and Huntington Bancshares are even borrowing to buy back their shares.
This at a time when banks sell at huge premiums to their book value.
These share buybacks dont change the economic value of these institutions or improve their franchise value, complains Salomon bank analyst Carole Berger. They merely increase the risk to shareholders during the next credit cycle. She notes that the capital ratio is starting to drop. In 1990, when it hit the fan, she recalls, there was no such thing as too much capital.
Are buybacks really bullish if company managements are buying in stock at their alltime highs? asks James Stack, publisher of a market newsletter, Investech. Where were all these buyback programs in 1990 and 1991?
If you believe in perpetual prosperity, all buybacks make sense. But we suspect a lot of managements will wake up some day and wish they had some of that money back. Its easier to shrink capitalization than raise money when it is badly needed.