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How Stock Buybacks Can Avoid Blowbacks

Credit rating agencies are beginning to worry about the use of debt for share repurchase...

Economist, Author, and Five Star Wealth Manager

Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.
Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.

via Giphy

In an article last year (“Rising Rates Don’t Necessarily Help Bank Stocks”), I warned against the pervasive use of companies taking on debt to finance stock repurchase and dividend programs. Stock buybacks have continued to be a favored (though slightly less so in 2016) CFO technique to boost earnings per share (EPS) reports (see chart below: FactSet source). This scheme has been a major fundamental driver of bull market strength, even though top-line revenues have remained stagnant. With interest rates set to continue their slow and steady march higher, credit rating agencies are now beginning to worry about the continued use of debt as a share repurchase funding source going forward.

Recently, a Fitch Ratings report has warned that many stock buyback programs that are financed through debt may result in a corporate credit quality issue. This ends up manifesting downgrades and negative outlook changes, though the report states that “most will be done in a credit neutral manner”. The figure that really caught my attention is that share buybacks ended up being 107% of free cash flow. Since 2014, this metric has continuously breached 100%. Bridging this cash gap with debt issuance is going to become more burdensome to companies, as the cost of new debt increases with rate hikes.

However, as one door closes, another is set to open – hopefully. I’ve repeatedly advocated in this publication for the Trump administration to focus on the favorable return of overseas US corporate profits, which would be a superior funding source for big dividend payouts and stock buybacks. This particular repatriation tax policy should be a hybrid between a repatriation tax holiday and a transition tax, but be optional, not compulsory to corporations. If properly designed and embedded within a broader US corporate tax reform, companies would have enough financial incentive, to not only bring back their accumulated foreign profits, but to do so consistently going forward.

By enacting this reform, the net effect on US corporate EPS figures would be the same stock price support, but at a much lower risk level. Instead of being funded with higher cost debt, companies would be able to allocate their repatriated cash to stock repurchases, which is inherently less risky. Better yet, the repatriated cash could be allocated towards actual business capital expenditures to boost economic growth. Finally, we can get away from these low-interest rate engineered, supportive stock price schemes, which add meager long-term value, at best.

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