Why low rates have fueled buyback boom, not corporate growth

Armed with record profits and loaded with cheap debt, big companies are spending heavily to shrink their stock-market profile rather than grow their business.

The stock-buyback craze has been raging for years, of course, as CEOs have looked to bolster stock prices, lift per-share earnings, goose their own compensation and appease activist investors by purchasing stock hand-over-fist from the public.

Yet the buyback boom is also rooted in deeply ingrained, arguably unrealistic, corporate standards for how much payback a new business expansion must promise in order to get approval.

And with investors now rewarding companies less generously for yet more buybacks and with profit margins already high, corporate America seems to be approaching a critical decision point about whether to push for more internal growth or continue using its billions to swap cash for equity.

Strategists at Barclays Capital point out that, with total buyback volume by companies in the Standard & Poor’s 500 near the 2007 quarterly peak, “capital expenditures are growing slowly” and the proportion of earnings retained by companies to propel future growth has slid sharply.

Buybacks have consumed the greatest share of incremental profit growth since the financial crisis, while the proportion of cash flow directed toward capex has stalled near 40%, down from above 50% in the early 2000s.

A new study published in Harvard Business Review argues that the zeal for buybacks is mostly about executive compensation and investor pandering, and is draining energy from the broader economy.

High hurdles for investments

Yet there’s more to it than pure short-term greed, it seems. Even as interest rates and economic growth rates have dropped dramatically, top corporate executives still mostly demand that any new business projects exceed an onerous double-digit percentage “hurdle rate” of future returns.

A 2013 Duke University/CFO magazine survey of chief financial officers showed corporate hurdle rates have remained steady well above 10%, even as companies’ cost of capital has dropped radically amid near-zero interest rates globally.

In a slow-growth world with little pricing power, CEOs and CFOs determining how to use their cash will almost always default to buybacks and dividends when required rates of return on new capital projects are so punitively high. A Federal Reserve blog post last year expressed some (perhaps belated) concern that corporate investment seems relatively unresponsive to lower interest rates.

John Graham, a professor of finance at Duke University’s Fuqua School of Business who oversees the quarterly survey, points out that companies typically calculate their weighted average cost of capital and then slap, say, a five percentage-point “fudge factor” on top of it to account for inherent risks of new ventures.

With capital costs so low now, that fudge factor represents a heavy burden for new investments to overcome, and “has the effect of keeping absolute hurdle rates relatively high.”

For sure, these onerous hurdle rates are rooted in a rational desire among top corporate executives to impose capital discipline on expansion-minded division heads. And, arguably, the world has not been begging for capital-intensive new productive assets during this moderate recovery.

But it also seems corporate culture has become overly focused on cost-stripping, labor-minimizing, cash-harvesting activities over long-term growth efforts.

Works until it doesn’t

Buybacks have certainly worked if the main goals were enhancing reported profits and supporting share values. Barclays estimates buybacks are responsible for two percentage points of expected per-share corporate profit growth.

The stock prices of the most aggressive buyers of their own shares have consistently outperformed the broad market during this bull market.

Interestingly, though, buyback leaders stopped outperforming at the start of 2014, possibly suggesting that the market views this activity as delivering diminishing returns at this point in the cycle.

Also, the efficacy of buybacks is most pronounced for companies that are also growing their profits nicely, such as Home Depot Inc. (HD), which has been reabsorbing some 6% of its shares a year while also posting strong bottom-line results. Heavy buybacks by companies with weak underlying growth have not generally been rewarded by investors.

This makes sense. In addition to being a reward for past innovations and investments, today’s profits provide the raw material for future growth. Using them predominantly to buy back stock and increase dividends is tantamount to eating one’s seed corn rather than planting it. The Barclays strategists view the under-investment in growth and low retention of earnings as one reason profit growth and stock valuations will be muted in coming years.

We’re now at the point of the cycle when, logically, CEOs should be prepared to redirect more cash to capital spending and cash acquisitions, for the long-term greed instinct to drive their focus outward rather than at reducing their stock-market footprint. It's unclear, though, whether they're ready to follow this logic.