by Franklin J. Parker, CFA
The Summary
- Markets responded favorably to last week’s data postings. The Fed’s preferred inflation gauge, personal consumption expenditures, came in with the biggest gain since 1983. Headline unemployment posted at a very strong 3.6%, and job openings remain very near their record highs. That said, consumers have begun to slow their purchases in the face of higher prices and that is a big concern for ongoing corporate earnings.
- Importantly, last week’s data gives the Federal Reserve plenty of cover to aggressively hike interest rates. After a 0.25% increase at their last meeting, a 0.50% increase at the next meeting is on the table. Inflation could easily erode people’s ability and willingness to spend, and companies are starting to reach the limits of their pricing power. Inflation, then, remains the biggest threat to ongoing growth.
- This week is a much lighter data week, with consumer credit, international trade data, and wholesale inventories on tap. I have grown more cautious in my investment outlook for 2022. While I still see growth in the back half of the year, I now believe that growth will come with substantial volatility. I believe markets have underpriced the risks of supply chain risks, inflation, and the intensity of the Fed’s response. The yield curve (a widely-watched and accurate economic indicator) has begun to act in a pre-recessionary way (which I discussed last week), and consumers are now having to make difficult choices. Caution is warranted.
The Details
Starbucks announced that they were ending their stock buyback program to redirect cash toward employees and expansion. This week we dig into the dynamics of stock buybacks and why Starbucks is likely the first of many companies to announce such a change.
First, what is a stock buyback program?
When a company earns a profit, they have to decide what to do with the cash: either reinvest that cash to expand the business, or return that cash to shareholders. We will talk more about the first one in a minute, but if a company decides to return the cash to shareholders how should it do so?
Historically, dividends were the preferred method of getting cash back to shareholders. In recent years, however, the preference for companies has been to “distribute” cash to shareholders via stock buyback programs. First, these programs are discretionary—companies can end them without making shareholders too upset (unlike dividends). Second, they are a more tax-efficient way of returning cash to shareholders. Because share buybacks increase the share price of the stock, the shareholder can choose when to realize the gain, rather than be forced pay the taxes in the year the dividend is distributed. And, of course, higher share prices are generally good for management, so that dynamic is at play, too.
Of course, the recent popularity of share buyback programs goes well beyond tax efficiency. But to understand this we need to understand how companies decide what to do with cash in the first place.
A company usually has multiple sources of capital invested into it. Debt investors lend money to the company, usually at a fixed interest rate and first claim on assets. Equity investors invest in a company with no guaranteed rate, and with last claim on assets. Because of the added risk, equity investors require a higher rate of return to keep their resources invested in the company than debt investors. From the company’s perspective cash is cash, whether it comes from debt or equity, the only difference is the cost of that cash. So, a company will find the proportion of debt and equity that yields the lowest cost to them. This blended cost is known as the weighted average cost of capital, and it is very important in corporate decision-making.
Anything the company chooses to do with its cash absolutely must return higher than the company’s weighted average cost of capital. Of course, investing in growth is the first thing we all think of when we think of a company investing its cash. However, growth takes time and comes with uncertainty (it may or may not work out). When capital costs are very low—as they have been for the past several years—it is more advantageous to borrow at very low interest rates and buy back company stock.
For example, a company with a weighted average cost of capital around 3% can spend several billion dollars on a stock buyback program and increase their share price by 4% that year. Rather than invest in growth, which may or may not pay off in several years, buybacks are a “project” with an immediate payoff and no uncertainty. Plus shareholders get tax efficiency!
However, the metrics change quite a bit when capital costs are higher. Suppose the same company now has a weighted average cost of capital around 7%. Now the company simply cannot buy enough shares to increase the share price by 7%. That “project” has become cost prohibitive. In that environment, the only choice is to invest in growth (or return cash through dividends).
Ultimately, as interest rates rise, investors should expect to see more and more companies abandoning stock buyback programs. And while that is a negative for prices in the short-run, it is a long-term good. After all, if companies stop investing in growth it isn’t too long before they stop growing. A return to more normal economic dynamics would be healthy for companies, their investors, and the economy as a whole.
Chart of the Week
As I have begun to discuss, there are indications that the US economy is entering the final stretch of this brief but powerful expansion. That does not mean we are at the end and this does not mean a recession is inevitable, but it does mean that investors should be expecting end-of-cycle market dynamics.
The index of leading economic indicators has begun to stall. As the chart shows, this indicator tends to stall, then decline, leading into recessions. Again, this does not show a recession is imminent, but rather that growth appears to be slowing. The longer this indicator flatlines, the more concerned we should be.
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