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There are a number of ways for corporate managers to allocate capital. They can use it to fund buybacks, dividends or acquisitions, pay down debt or invest in the growth of the company through capital spending. This last option, which consists of capital expenditures on physical assets as well as research & development - has been perceived as weaker in the current expansion compared to prior recoveries. Less robust business re-investment makes some investors nervous at this point in the cycle. Buybacks in particular have drawn the ire of critics, who call it financial engineering and suggest such action reflects a dearth of productive options for corporations.

There certainly are times when each one of the capital allocation methods mentioned above makes the most sense. Buybacks are currently favored by corporate managers, as we explained in a previous blog post; however companies have simultaneously been able to increase capital expenditures (Exhibit 1), albeit at a slower pace than earlier in the current expansion.

 

Exhibit 1: Capital Expenditures for Structures & Equipment

Source: Annual Capital Expenditures Survey, U.S. Census Bureau.

 

We believe the concern over buybacks signaling weakness in economic prospects is overblown. There are many good reasons why share repurchases are the preferred method of capital allocation at this point in the cycle. First off, buybacks and dividends are extremely important for a buoyant market. Exhibit 2 illustrates the correlation of increasing dividends and buybacks with stock prices.

Recent weakness in business spending can be attributed to sharp cutbacks in the energy industry over the last two years tied to falling oil prices, as well as the upcoming elections. Corporate managers do not like uncertainty when allocating capital for future growth. If the regulatory and/or tax environment drastically change with a new presidential administration, it’s hard to invest for an uncertain payoff. Until visibility is restored, buybacks represent a more prudent choice.

But we are still left with an important question: Does allocating capital to buybacks instead of funding growth initiatives hurt a company’s long-term profitability? Data suggests that it doesn’t, especially if share prices are depressed.

Spanish economist Silvina Rubio found that companies that reinvested in their shares during times of depressed prices created an environment that led to future capital expenditures and business reinvestment. Capital expenditures were twice that of non-repurchasers in the two years post announcement. How could this be?

In her research¹, Rubio found that companies that engaged in buybacks actually reduced their cost of capital. With lower borrowing costs and thus a lower hurdle to profitability, companies then had a greater incentive to increase investment.