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Stock Buybacks and Special Dividends

Written By Briton Ryle

Posted October 7, 2014

Despite the still sluggish economic recovery over the past 5.5 years since the 2008-09 financial crisis, you’d be surprised to learn that U.S. corporations are actually making a heck of a lot of money. You’d be even more surprised to learn what they are doing with it – they’re sharing it with their investors.

With corporate profits in America expected to reach some $964 billion this year, U.S. corporations are on track to spending $565 billion buying back their own company shares, and returning another $349 billion to shareholders through special dividends, as calculated by Bloomberg and S&P Dow Jones Indices.

That means some $914 billion – almost a trillion – will have been handed back to shareholders by U.S. companies before this year is over, which works out to some 95% of this year’s profits.

But before you start applauding their apparent magnanimity, we need to understand that all this money flying out the window through share buybacks and special dividends risks killing the bull run.

Over the past three months, some $230 billion in profits were earned by U.S. corporations, while $235 billion were paid out through stock buybacks and dividends – more than 100%. “The last time payouts exceeded income in 2007,” Bloomberg recounts, “equities peaked that October before losing more than half their value.”

Is the current exceptionally high rate of stock buybacks and special dividends a sign that equities are about to tumble? Is this the reason why so many shareholder activists have been pounding boardroom tables up and down Wall Street, demanding companies increase their payouts to shareholders? Are insiders trying to get while the getting is good, leaving us ordinary investors holding an empty bag?

The Risk of Stock Buybacks and Special Dividends

In many economists’ view, the greatest risk today lies in equities, whose prices have become over-inflated due to the lowest interest rates in American history for over five consecutive years. Ultra-low bond yields have forced investments into stocks, where many dividends are better than Treasury yields. This flood of investment has caused the S&P 500 broader market index to surge some 190% since the depths of the financial crisis in March of 2009.

What is more, these ultra-low interest rates have allowed corporations to refinance their debts at cheaper rates, borrowing new money at low rates to pay back older, higher rate debt, reducing their cost of doing business by reducing their interest payments, and thereby increasing their profits.

“Five years of profit growth have left S&P 500 [companies] with $3.59 trillion in cash and marketable securities,” reports Bloomberg. Adding to that cash stockpile, corporations have “raised almost $1.28 trillion in 2014 through bond sales, headed for a record.”

Money is cheap, and corporations are borrowing as much of this cheap money as they can by issuing ultra-low-interest corporate bonds. Such access to cheap money is perfect for a recovering economy; it’s just what the doctor ordered. Companies can now expand their operations, hire more workers, produce more, sell more, and everyone will be happier for it.

Only, that’s not what they are using their cash for. Instead of using it to grow their businesses, corporations are giving their cash to shareholders.

“Buybacks are something corporations can take control of and at low borrowing costs,” Randy Bateman, chief investment officer at Huntington Asset Advisors explained the recent stock buyback spree. “They’re a viable option.”

Indeed they are “one” viable option. But viable for whom? Institutional investors and shareholder activists, mainly.

Institutional and activist investors have had a hard go of it lately, as low yields in bonds have cut into their fixed income returns. They see corporations awash with cash which they acquired at ultra-low interest rates, and they see an opportunity to earn some free income by pushing corporations to issue special dividends – ultimately giving shareholders free money directly out of the company’s purse.

But while institutional investors and shareholder activists enjoy these share buybacks and special dividends as supplemental income to their dismal bond returns, corporations are putting themselves into a very difficult position going forward.

“We’re at a point you sort of question whether [payouts] can continue to rise from here,” Jonathan Glionna, head of U.S. equity strategy research at Barclays Plc. expressed his worry.

Chris Bouffard, chief investment officer at Mutual Fund Store reiterated the concern. “You can only go so far with financial engineering before you actually have to have a business with real growth. Companies have done about all that they can in terms of maximizing the ability to do those buybacks.”

Bateman added his voice to those sounding the alarm. “If management can’t unearth future opportunities for growth, as a shareholder, I lose confidence.”

Should Investors be Concerned?

Should we as ordinary investors be losing confidence as well? Should we, too, be worried that companies are misusing their cash, giving it away instead of growing their businesses?

Money flying out the window through share buybacks and special dividends may be helping institutions and other investors by augmenting their dismal fixed income earnings, but it comes at the expense of a company’s future growth prospects. All this cheap money might be better spent modernizing equipment, building new plants, researching new techniques and developing new products to ensure profits continue to grow well into the future.

“The reluctance to raise capital investment has left companies with the oldest plants and equipment in almost 60 years,” Bloomberg assesses corporate America’s negligence. “The average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to annual data compiled by the Commerce Department.”

Not since 1956 has America’s equipment and machinery been so old and degraded. Corporate America is dilapidated. So why are corporations ignoring their own companies’ obvious needs? Why are they throwing their cash out the window instead of reinvesting it upgrading their businesses?

“Buybacks have become sort of the low-risk medicine in the C suite,” chief market strategist David Lafferty of Natixis Global Asset Management answers. “The reality is capital expenditure comes with risk, significant amount of risk, especially in a slow-growth world. Buybacks offer a lot of flexibility.”

Ah, yes, this is the other side of the issue, that second side that every story has. In a slow growth economy such as we are currently in – not just in America but all over the world – spending too much on equipment upgrades, factory expansion, etc, actually results in locking-up cash in fixed assets that aren’t being put to work.

Take capacity utilization, for instance, which measures the percentage of production capacity currently being used. As noted in the graph below, after hitting a recent low of 66% during the 2008-09 financial crisis, U.S. production facilities have been slowing coming back online. Yet even after 5.5 years, U.S. facilities are still less than 80% utilized, meaning we still have more than an fifth of production capacity that is not being used. Given the still slow demand for U.S. products worldwide, there is no pressing need to invest in capital assets at the moment.

capacity utilization usa


Thus, activist shareholders can be heard coaxing corporate executives: “Since you don’t need the cash, give it to us. We can use it.”

In a way, though I hate to admit it, those clamoring for share buybacks may have a point.

Companies have access to very cheap money, which they should be borrowing as much as they can while they can. It makes for good long-term sense, since we know that debt will only grow more expensive over the coming years.

The question is, where should they put that cash once they’ve borrowed it? You refinance your older more expensive debt for starters, which is what many corporations were busy doing during the first few years of this low interest rate era. But now that they have already refinanced as much as they can, they are generating even more savings from lower interest payments. So where should they put all their cash now?

Into their own companies’ stocks. Buying back shares makes sense especially for companies paying dividends at a higher rate than the current borrowing rate. They borrow money at 1 or 2% interest and buy back shares saving them 3 or 4% in dividends. Share buybacks are a lot like refinancing older more expensive loans, only in this case they are saving more expensive dividend payments.

Later, when the global economy picks up, companies would resell the shares they’ve been buying back to unlock that stored capital to reinvest in their businesses.

So, yes, by diverting cash into its own shares a company is storing up for the future. But special dividends are a completely different story. These are payouts of cash to shareholders which the company cannot reclaim at a later date and put to use when the economy picks up. Once dividend payments go out, they never come back in.

By insisting on ever larger and more frequent special dividends, shareholder activists are sucking blood out of their own workhorses to their own peril down the road. Once the global economy picks up, these American corporate workhorses won’t have as much power flowing through their veins to mobilize for action quickly enough, and will be slow on the draw when the time finally arrives to upgrade and replace aging equipment.

Investors should always keep an eye on their holdings’ use of cash. A company that is paying an exceptionally high amount in dividends could be setting itself up for trouble down the line, and for us too as investors.

A high dividend rate may seem all fun and games in this sluggish period of the recovery, but it will be regretted in the coming years when the economy picks up and interest rates start to rise. Companies will then be borrowing at higher rates, kicking themselves for letting so much cheap money fly out the window into shareholders pockets.

Joseph Cafariello