The below is an extract from my 2015 book Dire Straits: Money for Nothing, Debt for Free
“It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their own companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”
—Larry Fink, CEO and Chairman of Blackrock, March 21, 2014
Generally speaking, there are seven major decisions that companies can make when choosing what to do with the money they have sitting on their balance sheet. The first three choices involve investing funds, either in upgraded plant and equipment, in acquisitions, or in the hiring of additional staff.
Those decisions cost money, but companies will only take that course if they see the potential for higher sales or more efficient production. In simple terms, while these decisions remove a bit of flexibility from the balance sheet (because a pool of cash is no longer free), the growth and future profitability of the business should be enhanced.
Companies can also choose to hold onto their cash. That won’t help them grow, but it does provide protection, for there’s nothing wrong with having a little rainy-day money sitting around. It also gives companies flexibility, as they can use that cash at any point in the future in the case that good opportunities arise.
The next option would potentially be to pay down any debt they might have. That won’t help them grow either, as it’s money they’re not investing in their business, but it will at least give the company peace of mind that those loans have been repaid.
There are two final options. Pay out higher dividends, or buy-back your own stock off the market. Rewarding shareholders through regular dividends is certainly a good thing, and it’s the sign of a disciplined organization, but companies can go too far. Worse still, feeling forced to pay out ever higher dividends because investors are desperate for any kind of yield in a zero- interest-rate environment definitely isn’t a good sign.
Furthermore, both higher dividend payouts and buying back your own stock reduce flexibility, which can have a negative impact on a company’s future prospects. That’s because doing so sacrifices a pool of capital companies would otherwise have been able to utilize at some point in the future.
Sadly, stock buy-backs and higher dividend payouts are exactly what companies have been focusing on since the GFC hit. Capital expenditure sustains longer-term growth, but it has been an afterthought, and remains incredibly weak today (as I discussed in the post-GFC chapter).
Starting with dividend payouts, Credit Suisse produced a report (after profit season in early 2014 in Australia) that highlighted the worrying trend I’ve discussed above. They highlighted the fact that while a full 50 percent of companies did not meet their free cash-flow targets, barely 20 percent missed their dividend-per-share expectations. As the report states, “We applaud companies attempting to keep their shareholders happy. However, we hope they are not spreading themselves too thinly.”
CEOs and company boards are loathe to disappoint dividend-hungry investors. A Commonwealth Bank 2015 report summarized Australia’s latest reporting season, stating that 75 percent of companies maintained or increased dividends. That is despite the fact that revenue growth was flat and net profits fell substantially.
As a final example of how worrying this trend has become in Australia, consider research released in early 2015 by Goldman Sachs. They noted that in Australia, between the 2010 and 2014 financial years, there was $122 billion in free cash flow generated by non-financial companies. Amazingly, those same companies returned $177 billion to shareholders through dividends and buy-backs.
A full 50 percent of companies are returning more in cash to shareholders than those companies are actually generating themselves. As you can see, money for nothing and debt for free hasn’t just infected governments.
When we look at the U.S. stock buy-back situation, the picture we see is truly astonishing. Rather than investing money in their own operating businesses, companies are increasingly using that money to buy back their own stock. An article that appeared in Bloomberg on October 7, 2014, reports that since the equity market started rallying in 2009, companies are estimated to have spent $2 trillion buying back their own stock.
Factset, who produce a Buyback Quarterly report, show similar numbers over that time period. They also highlighted that, based on their last set of results, annual stock buy-backs are now running at $567 billion per year. That’s an increase of 27 percent from the previous year. In other words, that’s $567 billion worth of cash that those businesses no longer have to invest.
Indeed, had companies (rather than buying back $2 trillion of their own stock) instead decided to hire workers at $50,000 a year, they could’ve employed an additional 6.5 million Americans for each of the past six years. I’m not blaming companies that are doing this. I’m sure they’d rather hire and invest in their own companies. But they know that the economy has changed, that there is no real recovery, and that demand is weak. They are, therefore, rightly nervous about adding to their payroll with any great haste.
They’re also under extreme pressure to constantly increase dividends, for investors are desperate for yield in a zero-interest-rate world—yet another unintended consequence of central banks meddling in our economies and our financial markets.
But what is more concerning is the fact that many of these buy-backs have been funded with borrowed money. Indeed, despite the mainstream financial-media focus on the amount of cash sitting on company balance sheets— which is near record highs—corporate debt levels have grown even faster in this post-GFC period. Higher cash levels imply robust corporate health and the potential for significant capital deployment, but analysis from Societe Generale highlights the fact that net debt levels for U.S. corporates are now some 15 percent higher than they were during 2008 and 2009.
This story got some overdue airtime in August of 2014, when Brett Arends, writing in Marketwatch, encouraged readers to “watch out for the corporate debt bomb.” He pointed to a $2.4 trillion increase in corporate debt outstanding for U.S. non-financial corporations, with these companies now carrying debts equivalent to 50 percent of their net worth. That’s much higher than long- term averages, and worse than where corporate debt levels were during the height of the GFC.
With interest rates at zero, none of this is causing problems just yet. But the idea that there will be no ramifications at all from this over the next decade or so seems unlikely.