by Alexander Green, Investment U’s Chief Investment Strategist
Monday, November 8, 2010: Issue #1383
For months, U.S. public companies have sat on record piles of cash – more than $1.8 trillion. Now, many are finally putting it to work.
But they’re not hiring more workers, building more factories, or paying down debt. Instead, they’re using the money to buy back their own shares.
So far this year, companies have announced that they’ll purchase more than $273 billion of their own shares. That’s more than five times as much as last year, according to Birinyi Associates.
Some economists argue that this money could be better put to work in job-generating activities that might produce economic growth. However, management’s first obligation is to shareholders, not economists or “the public.”
And if your business outlook is cloudy, you don’t want to commit that cash to building new manufacturing facilities or taking on new employees that aren’t needed.
Regardless of whether you’re an individual or a corporation, sitting on cash isn’t terribly rewarding these days, with the average money market fund paying less than one tenth of one percent.
So buying back shares makes good sense. Why?
The Share Buyback Boost
Because when you divide net income into a smaller number of shares outstanding, you get greater growth in earnings per share. And ultimately, that’s what drives share prices higher.
(If the economy shows more promise down the road, a firm can always do a secondary stock issue to raise capital for expansion.)
A partial list of companies that announced major share buybacks last month includes:
Why Share Buybacks Are Important… And What They Mean for the Market
Many investors recognize the importance of top executives buying back their own companies’ shares with their own money at current market prices (i.e. insider buying).
But they underrate share buybacks because they sometimes don’t do anything more than offset the new shares created by option compensation. (And, indeed, that is occasionally the case.)
But when a company announces a major buyback, it often means the executives and board of directors are betting their jobs that the company’s shares are undervalued.
Why? Because if management spends tens of millions of dollars of the firm’s money buying shares back and the stock is sharply lower in six months or a year, they may well be out of a job.
Yet history shows that share buybacks are generally well-timed. It’s a positive development for shareholders.
And the large number of share buybacks announced this year is yet another reason why the market should keep trending higher.