If you do a Google search on the meaning of the word 'fad', this is what you get, "An intense and widely shared enthusiasm for something, especially one that is short-lived; a craze."
Fads are fine in fashion where a typical person would want to wear something that is in vogue and not too out-dated. In the field of investing, fads are dangerous. Especially as the definition points out they are a craze and short-lived.
History has ample evidences of fads or themes that have caught the fancy of investors. Not just in India but in the global markets as well. Most of these have ended badly.
And one such fad doing the rounds especially in the US is share buybacks. Buybacks typically are one of the indicators of how companies are choosing to deploy cash. Companies having excess cash can utilize it in various ways (1) dividends to shareholders (2) share buybacks (3) investing it back into the business to pursue growth opportunities and (4) mergers or acquisitions or buying technology or brands.
In the US, loose monetary policies have bolstered the cash reserves of many companies. Indeed, quite a few have been capitalizing on the near zero interest rate scenario and going on a borrowing binge. But given that the US economy continues to remain weak, a lot of these companies are not really spending it on capex or R&D that can set the stage for the next round of growth. Instead, this cash is being used towards buying back shares. So while in effect, the EPS is increasing because of the buyback, in some sense this is illusionary because it is not backed by growth. And by not investing in the business, in some sense, these companies are hampering their own growth prospects in the future as well.
As reported in an article on Bloomberg, companies in the S&P 500 last year spent a combined US$ 890 bn on share buybacks and dividends, compared with US$ 702 bn on capital investment.
And this is where we would like to point out that buybacks are a tricky thing. Buybacks make sense if the company believes that its shares are undervalued in relation to its earnings prospects. Thus, the logic that you should buy shares of companies if valuations are reasonable applies to buybacks as well. This is not what one is seeing in the US. There, the excess liquidity has driven up the stock prices of many US companies to the point that valuations have become unreasonable. Thus, the companies are buying back their own shares at prices that are expensive. So while this may on the surface buoy investor sentiments because of the rise in EPS, what you need to also consider is that it ultimately reduces cash earnings to that extent. Secondly, borrowing money to fund buybacks is also not ultimately in the shareholders' interest in the long run.
In India, we are thankfully not seeing this fad. But we would like to point out that investors should not automatically assume that buybacks are always a good thing. The reason behind this move should be closely looked at. At the end of the day, an increase in earnings should be more a function of the inherent robustness of the company's business. Because that is what will help it grow at a healthy pace.
BY Radhika Pandit
Fads are fine in fashion where a typical person would want to wear something that is in vogue and not too out-dated. In the field of investing, fads are dangerous. Especially as the definition points out they are a craze and short-lived.
History has ample evidences of fads or themes that have caught the fancy of investors. Not just in India but in the global markets as well. Most of these have ended badly.
And one such fad doing the rounds especially in the US is share buybacks. Buybacks typically are one of the indicators of how companies are choosing to deploy cash. Companies having excess cash can utilize it in various ways (1) dividends to shareholders (2) share buybacks (3) investing it back into the business to pursue growth opportunities and (4) mergers or acquisitions or buying technology or brands.
In the US, loose monetary policies have bolstered the cash reserves of many companies. Indeed, quite a few have been capitalizing on the near zero interest rate scenario and going on a borrowing binge. But given that the US economy continues to remain weak, a lot of these companies are not really spending it on capex or R&D that can set the stage for the next round of growth. Instead, this cash is being used towards buying back shares. So while in effect, the EPS is increasing because of the buyback, in some sense this is illusionary because it is not backed by growth. And by not investing in the business, in some sense, these companies are hampering their own growth prospects in the future as well.
As reported in an article on Bloomberg, companies in the S&P 500 last year spent a combined US$ 890 bn on share buybacks and dividends, compared with US$ 702 bn on capital investment.
And this is where we would like to point out that buybacks are a tricky thing. Buybacks make sense if the company believes that its shares are undervalued in relation to its earnings prospects. Thus, the logic that you should buy shares of companies if valuations are reasonable applies to buybacks as well. This is not what one is seeing in the US. There, the excess liquidity has driven up the stock prices of many US companies to the point that valuations have become unreasonable. Thus, the companies are buying back their own shares at prices that are expensive. So while this may on the surface buoy investor sentiments because of the rise in EPS, what you need to also consider is that it ultimately reduces cash earnings to that extent. Secondly, borrowing money to fund buybacks is also not ultimately in the shareholders' interest in the long run.
In India, we are thankfully not seeing this fad. But we would like to point out that investors should not automatically assume that buybacks are always a good thing. The reason behind this move should be closely looked at. At the end of the day, an increase in earnings should be more a function of the inherent robustness of the company's business. Because that is what will help it grow at a healthy pace.
BY Radhika Pandit
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