Interactive Investor

Be bullish on the buyback blowback

19th September 2014 00:00

Ken Fisher from ii contributor

Few things in investing are as bullish as when the media twists a good thing into something bad - and people buy it.

Take stock buybacks. Buybacks are brilliant. Yet today, few see it. Many dislike buybacks. Some think they're a funny accounting trick to hide weak earnings and sad revenues. Others believe they're a drain, stealing money businesses should use to expand, hire, boost wages. A boon to no one but rent-seeking CEOs - the scourge of our inequality-obsessed politicians. Don't believe either claim.

When firms buy up their own stock, they reduce supply - great for prices. Simple Econ 101. This is smart financial management for the companies, who borrow cheap, buy shares in their increasingly profitable firms and pocket the spread. A boon for investors!

Buybacks aren't an earnings fake-out. They do boost the per-share measure of earnings and revenues - they reduce the denominator - but they don't touch the numerators, total profits and sales. Both are at all-time highs and rising. No accounting trickery there! Besides, boosting earnings per share increases each shareowner's slice of future earnings - a basic, fundamental reason to buy stocks in the first place!

Buybacks aren't a black hole

Nor are buybacks a black hole. The evidence for this claim is a recent study of how S&P 500 firms spent their money between 2003 and 2012. For the 449 firms in the index that whole time, the researchers found 54% of net income went to buybacks and 37% to dividends - and through simple math, the media inferred only 9% went to capex and wages.

There is a major flaw here. It ignores corporate borrowing! Many buybacks are funded with debt - simple arbitrage. So are investments in structures, equipment, product development and R&D. Companies can retain earnings, saving cash for a rainy day, and use their strong balance sheets to back a new bond or get a loan. This is why corporate cash balances and bond issuances are up huge in recent years. Business investment is up, too! Total US business investment has risen 13 straight quarters and is at record highs. R&D has charted new highs since 2010.

There is no evidence buybacks weaken capex. If they did, business investment would be noticeably weaker after 1982, when the SEC gave firms carte blanche to buy back all the stock they wanted. But inflation-adjusted growth rates before and after are fairly similar. Some point to CEOs' compensation packages, arguing paying bonuses in company shares incentivises executives to boost prices with buybacks, but this isn't true. CEOs must grow earnings and revenues, or they're fired - you can't grow a business if you don't invest.

Investment has grown slowly during this expansion, but buybacks aren't why. As I wrote last November, the Fed's quantitative easing squashed the yield curve, making banks hesitant to lend - too small a potential profit, not worth the risk. The Bank of England brought the same pain to Britain. Big firms floated corporate bonds - so S&P 500 capex held up ok - but loan-starved small firms couldn't invest. This is changing now, so get ready for a capex bonanza.

To blame buybacks for weak growth perversely twists something great for stocks into a drag - the sort of false fear bull markets thrive on. There are plenty others. Like the steeper yield curve - a time-tested positive, twisted to a negative by pundits wrongly worried higher long-term interest rates kill loan demand. Gridlock is another. Headlines deride do-nothing politicians as useless bickering blowhards, not seeing markets love it when radical laws can't pass. Even cash-rich corporate balance sheets - a sign of strength and fodder for future growth - are reviled as evidence of hoarding. You Brits are bombarded with headlines scorning strong domestic demand as a symptom of an "unbalanced recovery."

Stocks set to prosper

As long as the media forces bullish features to cross dress, these false fears are baked into prices, giving markets plenty more room to rise. With positives galore and false fears aplenty today, this bull market has a long way to go. Enjoy it with stocks like these:

It's hard to be a consumer staples firm with a strong growth story, but your very own SABMiller is. It's superstrong in emerging countries, where beer guzzling grows with income. While pricey, SABMiller should become a darling of this bull market's later stages, as growing staples usually do.

With Spain's crisis past, PIIGS debt normalising and Spanish banks having become a relative oligopoly, the stocks should be increasingly favoured. They haven't been yet. Banco Bilbao Vizcaya Argentaria is the second largest and global in reach. I like that almost no one forecasts earnings That's part of why it sells at only 12 times my 2015 earnings estimate, 1.2 times book value, and should yield 3.5% this year.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.