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Stocks will be buffeted as companies face skyrocketing cost of capital

The cost of capital, due to higher interest rates, will remain elevated for longer than most investors expect.

Marin Katusa is co-chairman and chief investment officer of Carbon Royalty Corp.

Investors in stocks, beware: It appears as if US companies will be facing major headwinds for the next few years. This is because the cost of capital is going to outweigh the return on invested capital.

This is already being shown in the “Big 7,” where Alphabet’s GOOG Google cloud isn’t meeting its growth expectations, and the case is the same for Amazon AMZN and Meta META .

It gets even worse for the companies whose cost of capital is much higher than the Big 7.

Companies utilize their cash flows for three primary uses: capital expenditure programs, share buybacks and dividends. All three ultimately affect their stocks.

Let’s look at share buybacks: To reward loyal shareholders and signal confidence in its future, a company announces a massive stock buyback program. Suddenly, everyone’s talking about what this means.

In the public markets, a stock buyback, also known as a share repurchase, is a corporate action where a company buys back its own shares from the marketplace. This process reduces the number of outstanding shares, increasing the ownership stake of remaining shareholders. It’s often seen as a way for a company to invest in itself, reflecting its belief that its own stock is undervalued.

Buybacks can positively impact the stock price, as they often lead to a higher earnings-per-share (EPS) ratio, making the company appear more profitable and attractive to investors.

However, they can also signal a lack of profitable growth opportunities and lead to questions about long-term value creation.

This financial maneuver plays a significant role in stock market dynamics, balancing corporate strategy with shareholder interests.

As you can see in the chart below, share buybacks became an important tool in the corporate toolkit and is the fastest-growing segment of cash uses.

What’s important for investors to understand about the share buyback plan is that the company has control over when and how much stock to buyback — and at what prices.

In some instances, a company may elect not to buy back its full allotment.

And now, cash flow and stock dividends: Let’s compare that to a dividend policy, which is approved by a board of directors and is fixed. It’s rare for a stock to sell off hard when it fails to buy back its full allotment of shares.

On the other side, it is common for dividend-paying stocks to get crushed upon announcement of dividend cuts or halts.

The chart below shows the three uses of cash as a percentage of the cash flow generated by the business.

If the ratio is above 100%, it means that companies had cash outlays greater than cash inflows in that year.

Over the past two decades, where investors were starved for yield most of the time, share buybacks and dividend payments represented lucrative inflows for investors.

Below is a comparison of the S&P 500 versus the top 100 S&P 500 buyback companies and the S&P 500 dividend aristocrats index. These are all compared on a total return basis.

The results speak for themselves.

Companies that increased shareholder returns via buybacks or dividend payments greatly outperformed the S&P 500.

Today there are only a handful of companies in the US that have a dividend yield greater than the 5.5% fed funds rate.

Given the rocky market conditions and the fact that the majority of dividend-paying companies are currently paying less than the Fed rate of 5.5%, it means that, in most cases, we are taking significant equity price risk and not being compensated for it appropriately.

Below is a chart that shows the number of companies with dividend yields exceeding the fed funds rate since 2000.

And now that the “amend, extend and pretend” is over, we expect many of these companies will not be able to continue the distribution payments. It will result in cuts to the dividend, which could lead to significant equity share price decreases in 2024.

The key takeaways:

I suspect that the cost of capital, due to interest rates, will remain elevated for longer than most investors expect.

This will put strain on corporate profits along with capital raising and capital deployment. In turn, this will negatively impact company growth rates.

This is not a situation that will be solved next week or next month, or maybe even next year.