What the share buyback frenzy is telling us

US firms are buying their own shares in record numbers, but there are potential long-term costs.

US firms are buying their own shares in record numbers. Last year, S&P 500 companies authorised $679.5bn of buybacks, a record annual figure. Already, 2015's strong start puts it on track to beat that. Like paying dividends, buybacks are seen as a way to return cash to shareholders. Reducing the shares in issue boosts earnings per share (EPS) and, in theory, drives up the share price.

But there are potential long-term costs. Using "spare" cash for share buybacks, rather than investing in new growth, suggests that a company has run out of ideas for creating long-term value. Also, executive compensation often depends on hitting earnings per share (EPS) targets this makes buybacks an easy way to juice their pay, even if there's no sensible business rationale for doing it.

And with interest rates at rock bottom, many firms are borrowing money to buy back shares undermining their balance sheets in order to push up EPS. "You're basically robbing your future [through underinvestment], and you're going to have a lower growth rate because of all this debt," says Mark McComsey of BHWM Asset Management.

Also, adds Avi Salzman in Barron's, history shows that companies have "terrible" market timing. It makes no more sense for a company to buy its own shares at high valuations than it does for any other investor to do so yet they tend to "buy high". For example, they spent 34% of their cash on buybacks in 2007, as the market topped, yet only 13% in 2009, when it bottomed. Goldman Sachs reckons they will spend 28% this year.

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