Understanding the Surge in Share Buybacks

Brett Hammond, Senior Economist

Brett HammondU.S. corporations are buying back their shares in near-record volumes, suggesting short-term optimism about the U.S. economy, but reservations about long-term growth remain. While companies that engage in share buybacks can be attractive for investors--given the anticipated rise in the price of their shares--it’s important to understand these companies’ views concerning long-term growth opportunities.

U.S. corporations have authorized $445 billion in stock buybacks this year, according to Dealogic. The year-end total is projected to be the third-highest annual total ever, trailing only 2006 and 2007, according to research firm Birinyi Associates.

Understanding buybacks
To understand the surge in buybacks, it helps to understand some of the underlying dynamics of the U.S. economy.

Nervous about the state of the credit markets and access to lending, many companies have chosen to keep cash on the books. In fact, U.S. companies are currently holding record piles of cash -- $2.1 trillion, among non-financial companies, at the end of September, according to the Federal Reserve. That accounts for 7.2% of all company assets – down slightly from the second quarter, when cash represented the greatest share of corporate assets since 1959. The cash holdings are derived from enormous earnings growth in recent years – about 35% annually in 2009 and 2010, and we project it to be about 10% in 2011.

Putting cash to work
Broadly speaking, companies can deploy their cash in three ways. One option is to re-invest in their business – such as opening new plants and facilities. However, the current sluggish U.S. economy has convinced many businesses that such investments would be ill-advised, because they don’t see attractive growth opportunities.

Another option is to pay dividends to investors. There have been modest increases in dividend payments, but companies are reluctant to increase them too much, knowing that there will be negative publicity when they eventually have to reduce them.

A third option is share buybacks. Buybacks tend to raise the price of a company’s stock for two reasons. First, an increase in demand for a company’s stock, no matter who is doing the buying, will help drive up its price. Second, by removing some of the company’s stock from circulation, it reduces the total amount of stock outstanding and makes the stock scarcer, which will also tend to raise the price of the remaining shares.

Share buybacks, while popular, are criticized by some on the grounds that companies should instead be reinvesting in themselves and planting seeds for future growth. Critics point to a study released in June 2011 by Fortuna Advisors showing that over a recent 10-year period, companies spending the most on share buybacks realized lower shareholder returns than companies spending the least.

Historically, share buybacks have been most common in the information technology and energy sectors. That trend is consistent with events in 2011. In the first and second quarters of 2011, companies in the information technology sector accounted for 23% of all buybacks, according to Standard & Poor’s.

The surge in share buybacks may be a sign that individual CEOs are cautiously optimistic about the short-term prospects for their own companies, and believe that sales growth is sustainable. The reluctance to invest in the company’s future may, however, suggest a longer-term pessimism.

Buybacks and investing
Investors looking at a company that has bought back shares should seek out the company’s views on the prospects for long-term growth. For example, are the share buybacks a signal the company does not see attractive opportunities for investment over the longer term? This is the kind of question TIAA-CREF fund managers ask of companies when making a decision about whether to invest in them.

Looking ahead to 2012, with the U.S. economic growth rate expected to continue rising, S&P 500 companies should see continued revenue growth – perhaps reinforcing their incentive to pursue share buybacks in large numbers.