US share buybacks loot the future

Observers of the US political scene complain about a dearth of leadership. The same is also true of the corporate world. Just as politicians are mesmerised by polls, chief executives are enslaved to the share price. Today's US bull market is sustained by one key ingredient: the share buyback. Profit margins are falling. Investment opportunities are apparently lacking. All that remains is to shrink the number of shares. America's buyback boom may not be a crisis of capitalism. But it is a warning sign. When companies put their chips on financial engineering they are betting against the future.

This year US buybacks are on course for the first time to exceed $1tn. It would be less worrisome were the binge confined to one or two sectors, say big oil and mature drugs companies. But that is far from the case. From Apple to Pepsi, chief executives in all sectors live in fear of the activist investor. Likewise, it would be less troubling if the trend were purely cyclical. But buybacks have been rising as a share of profits for more than 30 years. Last year, the S&P 500 companies spent 95 per cent of their operating margins on their own shares or in dividend payouts. To judge by the activity since January, buybacks are on course to exceed 100 per cent of profits in 2015.

In theory companies are meant to raise money from the stock market to invest in their future growth. Exactly the reverse is taking place. Last year, the volume of buybacks was $550bn, according to Bloomberg, while the amount of new money coming into the market, mostly into mutual and exchange traded funds, was just $85bn. During 2015 the trend has increased sharply. Not only have buybacks jumped: they hit a record $104bn in February. But investors have actually been withdrawing money fromthe market.

There are wise investors, such as Warren Buffett, who argue that share buybacks are a rational way for companies to dispose of idle cash. Mr Buffett has made a lot of money from his stake in IBM over a period where its profit margins have been falling and it has been struggling to find a new business model. Like many troubled behemoths, it has kept shareholders happy by buying back its own shares. Between 2004 and 2013 IBM spent $116bn in buybacks, which accounted for 92 per cent of its profits, according to a Brookings paper.

Doubtless General Electric, which recently announced it would sell off its non-industrial businesses, will also be able to buy some goodwill. The point of GE's divestments is to focus on its core industrial business. Yet its disposals will in the first instance help fund a $50bn share buyback.

On a company-by-company basis, Mr Buffett has a point. But Larry Fink, the head of Blackstone - the largest asset manager in the world with a $4.65tn portfolio - has a better one. In a letter to 500 S&P chief executives this month, Mr Fink accused America's business leaders of eating their own seed corn.

Their obsession with short-termism would come at the expense of the future, he said. "More and more corporate leaders have responded with actions that can deliver immediate returns to shareholders . . . while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth," he wrote.

Most chief executives, of course, won't be around to take the blame. In the meantime they are making hay at society's expense. Anything up to 90 per cent of CEO remuneration comes from equity-linked pay. Under remarkably lax Securities and Exchange Commission regulations companies can choose when and by how much to boost their executives' rewards with the timing of their buybacks.

Among efficient market theorists, maximising shareholder value remains the watchword. In practice MSV should stand for minimising social value. It is no accident that the rise of buybacks has coincided with the boom in downsizing. Why invest in your employees' skills when you can boost your earnings now?

It is tempting to believe the buyback boom will come to a halt when the US Federal Reserve puts up interest rates. A large chunk of the buybacks are funded by corporate bonds issued at historically low interest rates. Once Treasury yields start to rise again, it will become more expensive for companies to buy back their own shares with borrowed money. But the opposite is just as likely to happen.

The point of zero interest rates was to help reflate the US economy. Even before the end of quantitative easing last year, profit margins were falling. Since then, the rise of the US dollar has hit overseas sales, which account for roughly a third of S&P 500 revenues. A turn in the interest rate cycle is likely to boost the dollar more, thus further squeezing US corporate margins.

What will the GEs and IBMs do then? In an ideal world, they would weather the storm to focus on future growth. In the real one, they will be under even greater pressure to meet their earnings targets. Mr Fink argues that "corporate leaders' duty of care and loyalty is not to every trader who owns their companies' shares at any moment in time, but to the company and its long-term owners".

The future of the US economy would look brighter if its chief executives were listening.

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