Companies continue to allocate significant amounts of capital to share repurchases and dividends. This trend has largely been in place since 2009’s third quarter. More recently, companies have significantly ramped up merger and acquisition activity as well.
Source: Standard & Poor’s Corporation and Yardeni Research, Inc.
Share buybacks, is a topic we have discussed several times in the past (Thoughts of Share Repurchase Activity, Dividends vs. Stock Repurchase, Financial Engineering and Share Repurchases, Greed in the Executive Suite, and Share Repurchase Activity Remains Elevated). We believe share buybacks can represent an appropriate allocation of capital when management thinks the shares are undervalued. However, in our experience, most companies do not make share repurchase a value-based decision. Instead they allocate more money to buybacks because they have excess cash or are trying to “goose” per share earnings. According to S&P, 2015’s first quarter was the fifth consecutive quarter in which shares outstanding for S&P 500 companies declined. More than a fifth of such entities ended the first quarter with a year-over-year decline in their share count of at least 4%; nearly 300 companies reduced their share count to some extent during the quarter.
The profligate use of stock options as part of executive compensation is likely one of the drivers of this behavior as it makes the performance of a company’s stock a key incentive for managers. As a result, management may favor actions that increase the value of their stock options. It can take time for investments that allow a company to grow organically through such means as capital expenditures or research and development to bear fruit. Plus, there is no guarantee that such investments will be successful. Buying back stock or paying increased dividends is more likely to benefit a company’s stock price, and the impact is likely to be realized more quickly. As a result, companies opt to buy back stock or increase dividend payouts and allocate less capital to new ventures or to enhancing their existing business. Both investing less in the business and lowering the number of shares outstanding have a positive impact on earnings and a company’s share price.
In 2015, companies have increased the pace of merger and acquisition (M&A) activity to levels last seen in 2007, announcing roughly $2.15 trillion in M&A deals or offers globally. According to The Wall Street Journal, bankers and lawyers say the surge in activity is being driven by “…executives’ fear of being left behind by rivals who strike deals to make them bigger and more efficient. In many cases, companies are concerned that if they don’t gain heft through acquisitions, they will become takeover prey themselves.”
There are some distinct differences between M&A activity today and what was seen in 2007. In 2007, leveraged buyouts were in vogue. In a leveraged buyout, private-equity firms are the acquirers. Today, private-equity firms are often squeezed out by corporate buyers. Corporate buyers can often pay more because they can later cut duplicate costs.
The market is also reacting differently to deal announcements. According to Dealogic, in 2013, the stock prices of U.S. acquiring companies rose by an average of 4% from the day before a deal was announced to the day after announcement. In 2014, share prices rose 3%; so far this year, they are up nearly 4%. Between 2008 and 2011, the average acquiring company’s stock price fell.
At BWFA, we attempt to buy stocks of companies with a solid long-term outlook. We have little interest in buying shares solely because a company might be acquired or might make an acquisition. It is possible a company held in client portfolios could be acquired, but that would not be the reason we added the shares. We pay particular attention to how management allocates capital. If we feel a company overpaid for the shares of a rival, it could lead us to exit a position.