Wry & Dry

The train-wreck of share buy-backs

W&D is watching with interest the silent and unfolding train-wreck of the US stock market.  

Trainwreck

Is this the upcoming US stock-market?

Readers will have noticed last week's comment on the anomaly of declining profits of US companies and yet their increasing share prices.   As predicted, company profits are beating expectations, but the expectations were lowered so that companies would beat them.

The S&P500 is now just 1.8% off its all-time high.

W&D doesn't wish to alarm anyone, merely alert readers to another emerging problem.

Work with W&D on this...

Think of a company that issues shares to raise capital.  And then uses the capital to repay debt.  This is, generally speaking, A Good Thing.

Now consider the reverse.  A company borrows funds to raise capital.  And then uses the capital to buy-back its own shares.  This is considered, generally, to also be A Good Thing.

Hang on - one cannot have it both ways.  And W&D says, indeed, one cannot.

Consider the share buy-back.  At the moment, one of the drivers of the US share-market rally is companies buying back their own shares.  The weird thing is that shareholders, be they executives, directors or the person-in-the-street, will not want the company to buy low.  As would most investors.  They want to do the opposite: to maximise their personal capital gain.  And so to push up share prices.

Buying back shares also helps prop up stock prices because it reduces the number of shares outstanding.  And in many cases is undertaken to reduce the dilution that existing shareholders experience when companies award stock-based compensation to their executives and employees. By reducing the number of shares on issue, buy-backs increase earnings per share.

The problem is when companies borrow the cash to undertake a buyback: the borrowed funds don't get invested in productive activities. For some companies this is not a problem.  But for others it causes a downgrade in credit rating.

In the last 12 months, Moody's have downgraded 61 companies because of this financial engineering, up from 32, 12 months ago.

The last time these downgrades exceeded 61 companies in a 12-month period was in June 2007.  In the March quarter US companies repurchased $165 billion of stock.

The highest since June 2007.

W&D leaves it to readers to join the dots.