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Net Net: Promoting innovation and managing change

The rich get richer as stock buybacks surge

Trader on the floor of the New York Stock Exchange.
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As the stock market sets a series of historic highs, investors can thank companies for buying back their own shares at a near-record pace.

Repurchases and buybacks soared nearly 60 percent in the first quarter, putting a floor under a market that struggled amid a brutal winter and an economy that contracted at least 1 percent. Companies have used bargain-basement interest rates to borrow money for stock purchases, which have fed the equity market even as gross domestic product growth has stumbled along.

In all, corporations increased buybacks by 59 percent to $159.3 billion, according to S&P Dow Jones Indices. That's up strongly from the $100 billion for the same period in 2013 and a bit below the $172 billion high set in the third quarter of 2007, just before the financial crisis and market crash that sent indexes plunging 60 percent. The stock market index gained just 2.2 percent in the first quarter, but it likely would have been substantially worse without the buybacks.

"Companies bought more shares, reducing their share count, and got a tailwind in the first quarter," said Howard Silverblatt, senior index analyst at S&P. "The big question is, was it a one-shot deal to help through the poor weather of Q1, or was it the start of something new?"

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By many expectations, 2014 was going to be the year that corporate America stopped dedicating large portions of spending toward propping up share prices and instead would start using some of that cash toward growing their top-line revenues.

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Even as the stock market has roared back since the Great Recession, capital spending contracted by about 25 percent during the recovery. It is expected to rise 6 percent this year, according to FactSet. On an annualized basis, capex rose more than 9 percent in the first quarter, but it declined more than 2 percent from the previous quarter.

In addition to buybacks, spending this year has surged for mergers and acquisitions activity.

Global M&A has jumped 41 percent to about $882 billion, and has grown 44 percent in the Americas region, according to Dealogic. However, there's a catch: Withdrawn M&A activity has been huge as well, totaling $300 billion worldwide, about double last year's pace. Mergers also have mixed economic results, as they tend to improve company efficiency while also resulting in job losses.

While there has been some investor push toward increasing capex and M&A, it likely won't come at the expense of continued buybacks, which have been far more effective in driving market gains.

In fact, Silverblatt said the trend of actively reducing share count may just be getting started even after more than $1 trillion in buybacks since the March 2009 market trough.

Companies have taken advantage of the Federal Reserve's long-standing policy to keep short-term borrowing rates near zero so they can do buybacks without decreasing cash. Though the Fed is expected to begin raising rates in 2015, the increases likely will be slow and incremental, keeping short-term borrowing costs relatively low for years.

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The impact has kept earnings growing and multiples expanding, though companies did reduce cash on the balance sheet in the first quarter for the first time since 2012. Cash dipped to $1.85 trillion from $1.94 trillion, according to the latest Fed flow of funds data.

"The takeaway for investors is you need to look at that income statement," he said. "It's a legitimate use of cash by management. But you need to know where the growth is coming from and how much to pay for it."

To be sure, some market experts believe companies are in the late stages of buybacks and will start spending money on growing their businesses.

Jim Paulsen, chief market strategist at Wells Capital Management, said in a recent note that 1.8 percent employment growth and factory utilization at 80 percent historically have been benchmarks for when capex begins to rise, and both numbers are in sight.

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"The surge in M&A activity since late last year is a good sign corporations are likely to soon augment capital spending. As M&A opportunities lessen and as these deals become more expensive, it will soon be cheaper to 'build' rather than buy existing capacity," Paulsen said.

Indeed, deciding what's the best way for companies to deploy capital is going to turn into a pressing question for investors.

In prior years, investors were perfectly willing, and actually demanded, that companies hang onto cash and limit spending to buybacks.

"Right now the market is enjoying the atmosphere. It provides a halo effect," said one Wall Street strategist. "The share buyback formula has worked and will continue to work until boards say 'no more of this.' It's worked for the past five years."