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What I Care About This Week | 2022 Apr 04

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Photo by Johannes Plenio on Pexels.com

by Franklin J. Parker, CFA

The Summary

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.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

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