Market Drivers 3 (Buybacks):Investment, Hiring, Nah...Bonus, Bonus, Bonus !
This started out to be a straight-forward post on the shift from an economically driven market environment to a financially driven one. It's important - and is widely recognized if not diagnosed and analyzed
- that "liquidity" is behind a lot of what's been going on. It's turned into a three part set looking at the markets & the economics of liquidity (here ) and on the role of credit and leverage (here). The third leg of the stool that's pumping lots of cash into stocks AND pulling large/huge amounts of stock off the market is corporate buybacks using all that excess case from profits that aren't going into capital spending or hiring. Or dividends for that matter (personally I'd rather get the money back and decide for myself). Just to put it all in perspective, and maybe confirm that indeed things are a little unusual, take a look at the Fed data on "net equity issuance". It looks to me as if it started the '90s in neutral, grew slightly negatively until '98 (from stock options at technology firms ?) and turned back toward neutral. And then started sharply downward in '04 just about the same time the LBO buyout was coindicidently turning sharply upward.
Actually it's not a coincidence at all and is both driven by some of the same forces and being driven directly by the buyout boom. The theory of the latter is that going private improves the effectiveness of capital structure by increasing debt held and getting better returns thru leverage. Company executives prefer to reserve their powder for long-term contingencies so you have two views of the world. But with highly conservative investment plans, no accelerated hiring and no capex there was and is a lot of cash being thrown off that has to go someplace.
And on top of that as the amounts of firepower accessible to the LBO community exponentiated public company execs came under the same pressures to re-factor their capital structure as if they'd been taken private. That is, add lots of debt to the balance sheet and pay out the free cash in dividends or buybacks. Oh yeah, we should mention that shareholder and executive interests aren't entirely congruent here - buybacks keep stock prices up and bonuses are paid on stock prices. And it's actually gotten to the point where pubco's are borrowing to pay dividends and make buybacks. In other words, and this could potentially be really important, they are re-leveraging their balance sheets at what increasingly looks like the best the economy is going to be; i.e. when revenues, profits and cash flow have nowhere to go but down.
There's a whole seperate discussion here about whether paying execs to keep stock prices up in the short-term is good for the long-term (which we've also analyzed in the case of HD). And whether or not a better incentive structure wouldn't be to set the strategic goals and metrics thereof and pay for hitting those benchmarks. What a fascinating idea...we'll have to pursue its sometime.
Meanwhile we can ask whether re-leveraging the balance sheets to keep stock prices up at the expense of investment or hiring is a good thing. And what the downstream consequences, especially when that leverage is being put on at the best of the economy.From Irwin Kellner on Marketwatch we get this little gem of a pointed observation:
"... last year, companies put most of their surplus cash (of which they had plenty, thanks to the surge in profits and the surfeit of liquidity) into dividends and stock buybacks. As a matter of fact, last year was the first year ever that the blue chip firms spent more money on buying back their stock than on capital spending."
An interesting point indeed. Consider what it's saying - the best strategic option we can find is to 
buyback our stock because we don't see anyway to put it to work growing the company. And if we buyback our stock we get control rather than paying it out in dividends so you can re-deploy it to other industries, or even other assets that you think might do better. The chart puts a lot of that in perspective. Lots of debt went onto balance sheets in the 90's but it was used to buy a lot of equipment (and seperately to hire a lot of people. The late 90s was the first time both real wages and net new job creation had turned up in over a decade). All in all good for everybody. Now corporations have lots of "savings" but aren't putting it into re-building or growing the capital stock.
Oddly enough the punditrocracy has been reporting on this story since at least '04, and I think '03, and always concluding with the notion that lots of funds are available for investment. Which will then of course either keep the economy growing or even accelerate it. Judging from the chart we're just seeing basic replacement spending. NOT investment for new growth.
So, whether you're an employee, an investor, a stakeholder or one of the buyout and/or other investment folks you have to ask yourself is this what you want ? Consider my "textbook" case of Home Depot. After getting nicely compensated by pushing up earnings at the expense of the long-term health of the company but "upsetting" nearly everybody the board finally pushed Nardelli out after an activist hedge fund came to town as the new sheriff. In an earlier post we suggested six major strategic initiatives that HD needed to pursue to survive the housing downturn, stabilize the company and return to organic, long-term growth and profitability. ALL of those strategies - which are inter-dependent, require serious investment. Yet HD just announced a major buyback and dividends. Will their cash flow cover all three requirements - re-development, dividends (to payback the Hedgies) and buybacks ? An interesting question indeed.
Or consider Cerberus' in-process acquisition of Chrysler. What kind of investment funding will be required to recover that situation ? Where's it coming from ? And what kind of operating performance will be required from Chrysler in the short- and long-runs ? Even in the short-run serious additional funds will be required. And how many other companies, public, private or in the deal-stream, can this same sort of inquiry be made. I'd think it might be all of them.
These are really beginning to look like interesting times indeed, aren't they ?
It stikes me that enterprise performance is going to be an increasingly critical requirement for mere survival. But we'll see.
Update(20Jul07):
Share Buyback Boom:A look at why stock buybacks have been soaring, with CNBCs Scott Cohn. Apparantly my timing on topic is better than my market timing as coverage of this issue is picking up. Have to say this short little blurb doesn't have room for much depth but also have to say the sense of the comments is opposite of my conclusions.