According to a recent report from global research firm McKinsey &Company, many investors have been wondering if the massive share buybacks we have seen in large U.S. firms is going to hurt the future growth of these companies. McKinsey&Company’s Tim Koller says the answer is no.
Koller makes the case that these big companies are actually returning around the same percentage of profits to investors as they always have, but are doing it via share buybacks instead of dividends.
He notes: “Distributions to shareholders overall, including both buybacks and dividends, are currently around 85 percent of income, about the same as in the early 1990s. Instead, the trend in shareholder distributions reflects a decades-long evolution in the way companies think strategically about dividends and buybacks—and, more broadly, mirrors the growing dominance of sectors that generate high returns with relatively little capital investment.”
Companies prefer share buybacks to dividends
Koller points out that since the SEC loosened regulations on buybacks in 1982, there has been a gradual change in how firms distribute extra cash to shareholders. Dividends represented over 90% of aggregated distributions to shareholders before 1982, but in 2015 they now account for less than half as share buybacks have surged (see Exhibit 1).
[drizzle]It’s really all about flexibility for the firms. The value to shareholders is basically the same, but share buybacks give firms added flexibility. Execs understand that dividends are permanent, ie, investors tend to expect the dividend to remain the same or go up forever unless there is an unforeseen financial problem. On the other hand, a company can easily increase or cease share buybacks without nearly as much kickback from shareholders.
Companies continue to invest at above historical average rates
According to Koller, there’s also no real evidence “that distributions to shareholders are what’s holding back the economy.” He goes on to point out that on an absolute basis, American companies have boosted their global capital investments by an inflation-adjusted average of 3.4% a year for the last 25 years (and 2.7% for their U.S investments). Keep in mind that is well above the 2.4% average annual growth of the U.S. GDP.
Koller also highlights that replacement rates have remained similar: “Capital spending was 1.7 times depreciation from 2012 to 2014, compared with 1.6 times from 1989 to 1999. The only apparent decline is in the level of capital expenditures relative to the cash flows that companies generate, which fell to 57 percent over the past three years, from about 75 percent in the 1990s.”
This all actually makes sense when you consider how far the makeup of the U.S. economy has moved toward intellectual property–based businesses. Of note, medical-device, pharmaceutical and technology companies saw their share of corporate profits move up to 32% in 2014 (from 13 percent in 1989).
Moreover, given a firm’s growth rate and return on capital are the key factors in calculating how much it should invest, that means high-return enterprises like these can invest less capital and still reach the same profit growth as firms with lower returns
Backing this up, intellectual property–based businesses represent around 32% of corporate profits today, but just 11% of capital expenditures (ranging from 15 to 30% of cash flows. Over the same 25 year time period, sectors with low returns on capital, including automobiles, chemicals, oil and gas, paper, telecommunications and utilities, have seen corporate profits cut in half to 26% in 2014, from 52% in 1989 (see Exhibit 2).
Analysts at RBC Capital disagree. They state in a report today:
Financial engineering/buybacks” continues to be a theme of Q3; 75% have beaten on the EPS line (above average) but only 44% are beating on the revenue line (vs. 55%) average over recent quarters.