Corporate stock buybacks are suddenly taking a lot of long overdue criticism.
Unfortunately, they are being attacked for the wrong reason.
The critics believe that these buybacks are launched to line the pockets of a self-serving top management. The underlying motives may indeed be crass, but that is neither surprising nor all that relevant. The real problem is what corporate stock buybacks tell us about the future.
At heart all financial markets are about the future. Understanding how that works is the key to reading the market – as an analyst, an investor, or like most of us, just trying to make our way through the maze of modern life.
It’s not true that understanding the stock market means that you have to leave logic and reason behind. It helps to remember, though, that the stock market reflects a large number of individual decisions we make. And as each of us knows all too well we don’t always act rationally. The best we can do is act that way most of the time – and that’s all we can expect of the stock market, too.
The beauty of large, free markets is that we can see the economic forces at work. It’s like one of those wristwatches with a transparent back – you can look in and see the works.
In the stock market, for example, a corporation’s good news about profit encourages investors to buy a stock, while disappointing growth in sales will often prompt a sell-off.
This doesn’t happen every time, of course, because profit and sales data reflect the past, not the future. Investors, for example, may believe that a company has rosy prospects despite disappointing recent results.
The real action in financial markets is propelled by expectations. The current prices of most, if not all, financial assets depend on expectations about what the future will bring. If those expectations change, the current market price will change. That’s why market analysts are constantly trying to assess the mood of investors, for that can provide a clue to their expectations.
Emotions, for example, can and often do play a part, as do things like investors’ personal economic situations. Investors’ reaction to layoffs, for example, might be very different for stockholders who are looking forward to higher corporate profitability compared with employee-stockholders in the companies that are eliminating jobs.
Millions of Americans are stockholders, either directly as individuals or households, or indirectly through pension plans of one sort or another. The Federal Reserve estimates that 49.7 percent of the middle income families in the U.S. own stocks.
Their expectations – reason, emotions, and moods included — are a determining factor in whether the market goes up or down on any given day, or in any week, month, or year.
One important factor driving our expectations is the overall economic situation. If the economy is healthy and enjoying robust growth and job opportunities, our expectations tend to be positive. If the economy is sluggish, though, our expectations tend to be dreary and we find reasons to be cautious or even negative about investments.
Corporations tend to be the same way. In an economy like ours that seems locked into sluggish growth, corporations tend to have modest expectations for growth in sales and profits.
In a situation like that, corporations tend to be very cautious about their investment projects, just as individuals are. What would be the point, or the reasonableness, of a company’s investment in higher production capacity, for example, if it doesn’t expect sales to grow very much? It might reasonably invest in technology but that is always something of a gamble, which makes most corporations nervous.
Faced with accumulating cash from profits, then, some corporations decide to buy back their own stock. This raises earnings-per-share, because there are fewer shares outstanding. Higher earnings tend to raise stock prices, which makes stockholders happy and the top management executives whose pay is tied to stock prices very happy.
Except for the critics, everybody seems either happy or very happy, so what’s wrong with this?
There are two things wrong, actually, and both spell out danger. The first is that the corporation is trying to engineer its own stock price and that is not something that should be encouraged for it often leads to even more questionable tactics.
The second is that both the company’s management and its stockholders are focusing on a short-term gain and losing sight of long-term implications. A corporation’s purchase of its own stock indicates that it has no better use for the money. This hurts its growth and innovation, certainly, and should signal to investors that management lacks a business model that matches the economy. That is likely to mean big trouble in the long run.
James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.
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