Why Stock Buybacks Will End Up Being a Terrible Investment for Companies

Great Stock Buyback MirageIn these pages, I have been very critical about stock buybacks by companies on the key stock indices. I see them as nothing more than a form of financial engineering used to manipulate per-share corporate earnings…and a bad investment for the companies buying their stocks back.

According to data compiled by Bloomberg and the S&P Dow Jones Indices, companies on the key stock indices are expected to spend $914 billion on share buybacks and dividends this year. Looking at it from their corporate earnings perspective, public companies will be paying out 95% of what they earn. (Source: Bloomberg, October 6, 2014.) Look at it this way: for every $100.00 of corporate earnings, they are paying out $95.00.

Almost $2.0 trillion has been spent by public companies on stock buybacks since 2009.

When companies increase buybacks, all else unchanged, they show an increase in their per-share corporate earnings. Some of the biggest names in key stock indices are doing this. FedEx Corporation (NYSE/FDX) was able to increase its per-share corporate earnings by seven percent, almost all directly related to its stock buyback program (reducing the amount of shares it has outstanding).

Why do I think stock buybacks are bad?

Over the past few years, companies on the key stock indices, by buying their own shares back and removing them from the market, have created a mirage that business is good because their stock prices are rising.

But business isn’t better. If the S&P 500 companies are spending 95% of their corporate earnings on share buybacks and dividends, it means they are spending very few dollars on growing their business.

According to Barclays PLC (NYSE/BCS), companies in key stock indices have significantly increased their cash flow towards buybacks—doubling what it was in 2002. Meanwhile, capital spending (money spent to grow a business) has declined more than 20% over the same period. (Source: Ibid.)

As a businessman of 30 years, I don’t grow my businesses by taking money out and reducing the amount of shares outstanding; I grow my businesses by re-investing the money my businesses make back into the businesses—hiring staff, creating or buying technology, expanding into different markets, and so on. That is how businesses are built.

Going back five years, when the U.S. economy was in the midst of a severe economic downturn, the Federal Reserve jumped in to help kick-start the economy. The hope was that the companies would borrow money and spend it on new projects and creating jobs.

And companies did borrow. In fact, companies on key stock indices are overly capitalized. The S&P 500 companies have accumulated $3.59 trillion in cash, borrowing about $1.28 trillion through bond sales. But I see most of that money going to stock buybacks as opposed to business expansion. The amount of money spent on share buybacks is draining capital spending—something we desperately need to spur economic growth in this country.

Can the companies on the key stock indices continue to buy back their shares forever? Of course not. As this stock market continues to crash lower, the billions public companies have spent on buying back their stocks will look like a terrible investment.