Stock Buyback Warning

While a stock buyback warning may appear to be a contradiction in terms, it is far from it in today’s market.

We all know that the primary mission of a publicly traded company is to generate profits, more commonly referred to as earnings on Wall Street. But after the profits are earned the company must do something with the cash.

While it may be prudent for the company to hold some cash for future needs, shareholders don’t like to see the “war chest” get too big. From their perspective this idle cash needs to be invested by the company to increase future earnings or be returned to the shareholders.

If the company can see an opportunity to grow their business by building new stores, expanding their factory, hiring more workers, or investing in research and development they will reinvest the profits to grow future profits. But if the economy simply isn’t presenting any good opportunities they’re not going to take the risk.

If the company can’t come up with a more productive use of the profits they may choose to initiate or increase their dividend payments to shareholders. But first the company must determine if current profits are sustainable to pay the dividend in the future. Shareholders are happy to see an increase in their dividend check but become very unhappy if the company decreases it later.

If all else fails, the company may choose to buy back shares of their stock from current shareholders. This will drive up the value of the shares because new buyers will be willing to pay a higher price for a larger piece of the company. This makes existing shareholders happy.

While the financial media likes to cheer when a company announces a stock buyback, what is it really telling us? It’s telling us that the risk in the current economic environment is too high to invest in expanding their company and the company doesn’t believe current earnings are sustainable to support future dividend payments.

While this may not seem very alarming when only a handful of companies choose to buy back shares, what does it tell us when it’s the latest fad on Wall Street?

According to the August 16th issue of “The Economist” and data services company “Trim Tabs”, companies purchased $671 billion worth in stock buybacks in 2013 and have made plans for nearly $300 billion already this year. “That is more than four times the money placed into stock funds by retail and institutional investors.”

“Like a snake swallowing its own tail, the corporate sector is absorbing its own equity. How long this can continue is anyone’s guess. The peak year for share buybacks was 2007, just before the debt crises. That is not a great omen.”