Stock buybacks have hit record levels - but what's driving the growth is dangerous for you and our economy.
Total stock buybacks for 2014 amounted to $696 billion, or 4% of U.S. gross domestic product (GDP), according to Research Affiliates. That's a lot spent on a practice that used to be tightly regulated by the U.S. Securities and Exchange Commission because it was considered manipulative.
And buybacks are manipulative. They make sense for some companies, but now they're often used to inflate stock prices – and make executives rich.
The truth is, most of today's stock buybacks are not only unproductive for the long-term health of corporations, but destructive in terms of economic growth.
Here's how bad the stock buyback "con game" has become - and how we can fix it...
How Stock Buybacks Became "Good"
Companies used to not be allowed to buy back their shares in the open market. The Securities Exchange Act of 1934 implied large-scale stock repurchases by a company could be construed as an attempt to manipulate its stock price.
That was "fixed" in 1982.
Newly appointed SEC Chairman John S.R. Shad, a former vice chairman of E.F. Hutton & Co. who sat on 17 corporate boards, pushed through Rule 10b-18. This rule gives companies a "safe harbor" for buying back shares, meaning manipulation charges would not be filed if they followed certain purchase guidelines.
Now, not all stock repurchase programs are bad. They make sense if a corporation's earnings history is steady, if its future earnings prospects are good, and if its share price is currently undervalued.
The cost of buybacks should be weighed against a company's free cash flow (FCF). You find that by taking operating cash flow minus capital expenditures from fixed assets and cash dividends paid.
Apple Inc. (Nasdaq: AAPL) is a good example of a company that can justify massive buyback programs.
Apple has repurchased $56 billion of its own stock in the past 12 months. Even after that, Apple is still sitting on over $200 billion in cash. It has also raised its dividend out of its increasing free cash flow and spent $7 billion on capital expenditures in 2014.
Apple can easily argue its stock is undervalued since it's trading at a trailing price/earnings multiple of about 13.2. Competitors trade at much higher multiples. Google, now known as Alphabet Inc. (Nasdaq: GOOGL), trades at a PE of 35.7. The market trades at about 18.5.
But now companies repurchase shares because they're unable to organically grow earnings by reinvesting cash back into the business. When managers see declining return on capital from operations, or when they see no worthwhile mergers or acquisitions to grow core business lines, they turn to buybacks. They can financially engineer higher earnings per share without boosting gross earnings or net income.
Looking at their cash flow shows the unhealthy consequence of buying back too much stock...
This Ratio Is Creeping to a Dangerous Level
Since 2004, U.S. corporations have bought back more than $7 trillion worth of stock, according to the Academic Industry Research Network. The trend has accelerated over the past few years.
The total buyback amounts are staggering - and what's more worrisome is where the money is coming to pay for them...
For the trailing 12-months ending in July 2015, free cash flow at S&P 500 companies totaled $514.4 billion, a 28.6% decline from the previous 12-month period. Companies' free cash flow in Q2 2015 was the lowest since Q3 2009.
As free cash flow has been falling, the buybacks-to-free-cash-flow ratio has been rising.
FactSet reported that the Q2 dollar amount of buybacks-to-FCF ratio exceeded 100%. That's the highest ratio since October 2009.
What's worse is when the dollar amount of buybacks exceeds a company's free cash flow, like it has lately, debt is issued to keep the buying binges humming along. And some corporations are going into serious debt to finance their stock buybacks.
According to The Wall Street Journal, in the first nine months of 2015, U.S. corporations issued $1.2 trillion of debt. Proceeds from some of the largest issuers, including Microsoft Corp. (Nasdaq: MSFT), Qualcomm Inc. (Nasdaq: QCOM), and Oracle Corp. (NYSE: ORCL), were "earmarked for share repurchases and dividends."
But buybacks are no guarantee that bid-up share prices will stay up...
Last year International Business Machines Corp. (NYSE: IBM) spent almost $20 million in buybacks when its stock was around $190. And whatever IBM spent in 2015 has been a total waste of money. Its stock is trading around $138 now.
Exxon Mobil Corp. (NYSE: XOM) spent $13.2 billion on buybacks in 2014, when its stock was in the mid-$90s. Whatever it spent in 2015 so far hasn't helped the stock, which traded below $70 a couple of weeks ago, and is only back up around $83.
And since companies are wasting billions on buybacks in the later stages of an extraordinary bull market, they pay increasingly higher prices for their shares.
This is money that could go to employees and to business growth. Instead, it drives only short-term gains. This at a time when economic growth has been averaging an anemic 2.4% and most of the employment gains have been part-time and low-wage jobs.
But they continue because of who is benefiting the most from record-high stock buybacks...
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.