Friday, December 12, 2008 0 comments

Statistic of the day

Floyd Norris of The New York Times, in his Notions of High and Low Finance blog, highlights some interesting numbers from S&P on capital allocation decisions by companies:

Over the last four years, since the buyback boom began, from the fourth quarter of 2004 through the third quarter of 2008, companies in the S.&P. 500 showed:

Reported earnings: $2.42 trillion
Stock buybacks: $1.73 trillion
Dividends: $0.91 trillion

Now, you can read all sorts of things from these numbers depending on how you look at the situation. I will note that the time period is very short (4 years) hence the numbers are not statistically rigorous. Here are my thoughts:

Companies spent $2.64 trillion in total on buybacks and dividends while earning $2.42 trillion. This gap may be due to misalignment of reported earnings versus buybacks/dividends (i.e. you earned a lot in 2003 but paid out dividend in 2004.) It could also be because of non-cash charges to earnings (e.g. depreciation, write-downs, etc.) But it does seem that sizeable amount of debt was issued to buyback shares and dividends (since one would expect earnings to be much higher than buybacks+dividends.) Levering up was a popular trend and, although some think it's risky, I'm generally favourable towards it if the balance sheet is strong. Interest rates were very low a few years ago and it would have been fine for companies to issue debt and buyback shares or issue dividends. However, it is almost a certainty that some executives of poorly performing companies would have levered up and tried to keep share prices up or issue dividends to placate the market.

I don't know how the long-term numbers look but my newbie view is that very little seems to have been re-invested. We can't tell from these numbers alone since we don't know how much of the earnings constituted non-cash earnings charges. Reinvesting capital rather than paying it out in dividends or buying back shares is always better for shareholders and society. This is one reason Warren Buffett does not buy back shares or issue dividends (Berkshire, in its early days, paid a dividend once and Buffett said it was a huge mistake.) Shareholders end up with higher returns and lower taxes. It's difficult for the average investor to get a return anywhere near what a company can. Long-term ROE for American corporations is around 12% and very few investors can re-invest at 12%. Society also benefits from higher reinvestment because reinvesting capital will increase wealth in the future. The only exception, of course, is firms that destroy wealth (for such firms, shareholders and society would be better off if the company paid out a high dividend and avoid pumping more money into the company.)

The above statistic indicates that almost 2x the amount of money was spent buying back shares as was issued in dividends. I prefer stock buybacks over dividends* so I'm ok with the actions taken by corporate America. The problem with stock buybacks is that they can destroy shareholder wealth if the company buys back overvalued shares. Hopefully the corporations bought back more shares in 2003-2004, when share prices were generally lower, than in 2006-2007. Unfortunately, it wouldn't surprise me if executives spent huge sums buying back shares at the peak. Instead of the continuous buyback strategy, I wished that corporations would simply sit on cash and deploy it well after their share price has collapsed. However, modern investors, who tend to be short-term oriented and are composed of hedge funds, would not approve of such a strategy.

(* Stock buybacks vs dividends: Buy backs are almost always better. The exception is if the management is reinvesting into wealth-destroying firms or at severely overvalued prices, but I would argue that one shouldn't own such firms in the first place. Buy backs have lower taxes (in Canada, capital gains is taxed less than dividends); and can compound at rates I can't easily get elsewhere. But all this is assuming that management isn't buying back shares that are overvalued.)


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