Sale of the century

Apr 26th 2007
From The Economist print edition


Companies are buying back their own shares at a record rate

BUY now while stocks last. The retailers' traditional slogan is being re-enacted in the American stockmarket. The supply of quoted shares is shrinking fast.

The biggest buyer is the corporate sector itself. According to Tim Bond, of Barclays Capital, American companies acquired (via takeovers and buy-backs) some $602 billion of shares last year. In the fourth quarter, the pace of purchases was running at an annualised rate of 6% of the entire market. April 23rd was the biggest day for takeover announcements since the AOL/Time Warner deal of January 2000 and the following day saw IBM announce a $15 billion buy-back. With that kind of support, it is hardly surprising that investors can shrug off economic and geopolitical concerns and push the Dow Jones industrials to a new record above 13,000, as they did on April 25th.

Mr Bond says this equity-buying splurge is almost exactly matched by the corporate sector's financial deficit—in other words, companies are borrowing money to buy back shares. This gearing up of the balance sheet is occurring when profit margins are at their highest level since the 1950s. It looks like hubris.

Investors are divided, however, between those who believe that profits are sustainable and those who feel they will inevitably revert to the mean. The bulls argue that the balance of power in the global economy has shifted decisively in favour of capital, at the expense of labour. The ability to outsource production to Asia is holding down wages. Improved economic stability makes life much easier for businesses to plan. All this means that the profit share of GDP should fluctuate around levels associated with the 1950s and 1960s, not the 1970s and 1980s.

Indeed, that businesses are buying back shares, rather than investing in new plant and equipment, may help sustain the cycle for a bit longer. Traditionally, business investment in capacity at the peak of the cycle has increased competitive pressures, dragging down margins. However, businesses' reluctance to invest may not be a good long-term sign. Pessimists, such as Mr Bond, would suggest that investment is needed to sustain profit growth; optimists would argue that investment is taking place, but in China and India, rather than in Europe and America.

Smithers & Co, an economic consultancy, takes a gloomy view, arguing that American profit margins are reverting to the mean and thus the prospects for company earnings are all downhill from here. It has observed an inverse link between profit margins and personal savings, which are very low in America. This creates the risk of a vicious circle in which any fall in the stockmarket will push up personal savings, depressing profits and hurting the stockmarket further.

The recent profits trend is far from clear. The latest figures from Morgan Stanley show annual earnings growth for S&P 500 constituents in the first quarter has been 10.3% to date, six percentage points above expectations. Around two-thirds of the results have been ahead of forecasts.

But this may reflect the recent trend for companies to play down their prospects and thereby ensure their numbers look good when they eventually appear. This trend has existed ever since the Enron and WorldCom scandals (and the subsequent Sarbanes-Oxley law) and probably relates to the desire of executives to avoid being sued or prosecuted.

It is hard to see how profits can keep growing at a double-digit percentage rate. Cost pressures are increasing, thanks to higher commodity prices and tighter labour markets (American unemployment is at a six-year low). Despite good results so far, HSBC says forecasts for 2007 earnings per share for S&P 500 companies have edged down from $95 in the middle of last year to less than $93 today. And Dave Rosenberg, a Merrill Lynch economist, says that, over the past six months, business sales have fallen at an annual rate of 2.3%.

If business conditions are getting more difficult, a bit of financial engineering will help. Buying back shares with borrowed money boosts earnings per share, so profit growth can continue to look healthy. That was an important driver in the final stages of the 1990s bull market.

In the long run, this is not sustainable. But so far, investors do not seem to have noticed. Slowing profits forecasts have been offset by an increase in the prospective profits multiple on American shares. Corporate borrowing rates are at cyclical lows, increasing the incentive for companies to buy back shares and for private-equity groups to launch takeovers. For as long as that buying spree continues, those who worry about the long-term will look out of touch.