The buyback game may finally be coming to an end. One can hope at least. Over the last decade, many U.S. companies levered up their balance sheets to repurchase shares. Why did they do it? For starters, it drives share prices, and in turn the value of executive stock options, much higher.
Why finance the buybacks with debt? Look to Mr. Powell and Mrs. Yellen and Mr. Bernanke at the Fed for keeping interest rates at ultra-low levels for an entire decade.
The Fed will, of course, escape any blame for this debacle as it did the Financial Crisis, but the evidence should be clear as day for anybody who cares to look closely.
“When the dust settles, we need to discuss the long-term impact of excessive stock buybacks on the health of the economy,” writes Bill Galston.
As Covid-19 spreads and the economy falls off a cliff, a debate has erupted about public assistance to large corporations. Defenders of a generous response argue that although big companies find themselves in need of help, it is not their fault. To slow the spread of the disease, government has driven down demand—to near zero in many cases. So government isn’t bailing anyone out, as many believe it did in 2008 and 2009; it’s compensating corporations for the harm that nature and public policy have inflicted on them.
This story is true. But it’s not the whole truth. Since the end of the Great Recession (a name we may have to reconsider if current trends continue), S&P 500 corporations have engaged in an orgy of cash-draining stock buybacks, much of it financed by increased debt. A 2019 Bank of America study found that over the preceding five years, buybacks by these corporations totaled $2.7 trillion while their debt rose by almost as much—$2.5 trillion. Between the summers of 2018 and 2019, buybacks exceeded free cash flow (cash earnings minus capital expenditures and interest payments). As a result, nonfinancial corporations drained their cash reserves by $272 billion.
This strategy of leveraged buybacks works fine while everything is going well. The number of shares outstanding shrinks, earnings per share increase, and stock values soar—all financed with low-interest debt courtesy of the Federal Reserve. In 2018 alone, according to Bank of America, buybacks increased reported earnings per share by 21%.
The problems start when the music stops. As demand for goods and services collapses, corporations are forced to do everything they can to preserve cash, a task made more difficult by the unrelenting pressure of debt service. As buybacks dwindle, so does demand for equities. The dynamics that accelerated the rise in stock values during the bull market now accelerate their decline.