Fix your mind on a pair of percentages: 73% and 27%. These two figures hold the key to why the long-term appeal of stocks remains quite bright (even if many investors would welcome a pullback in the near term to uncover deeper values).
Those two figures represent the current state of corporate largesse to shareholders, and the amount of firepower they hold in reserve. Fully 73% of corporate cash flow (among companies in the Russell 1000) has been earmarked toward share buybacks and dividends over the past four quarters. More specifically, companies spent $455 billion on stock buybacks on a trailing 12-month basis and another $366 billion on dividends, according to analysis by J.P. Morgan.
Source: J.P. Morgan
Companies are parting with so much cash because they already have too much of it. The sharp growth in cash flow over the past four years, coupled with weak levels of capital spending and acquisitions, have pumped up balance sheets to levels not seen in many decades.
What should we expect in coming years? Buybacks and dividends at least as robust as the current pace, or perhaps even much higher buybacks and dividends. It all depends on the economy.
The amount of money in question is the other 27% of cash flow that is not being spent on dividend and buybacks. Companies have largely been putting that excess cash aside, bolstering the balance sheets even more. Now, companies are faced with a conundrum: Should they apply that 27% of cash flow toward capital spending and acquisitions? That’s a real possibility — if the U.S. economy starts to get stronger. I discussed this topic a few days ago in this companion piece.
But what if the economy remains mired in a tepid 1.5% to 2.5% growth range? That could lead many CEOs to simply stand pat, holding off on any major capital spending hikes or growth-inducing acquisitions. And if that happens, that 27% figure we discussed will be increasingly applied towards buybacks and dividends.
Think it can’t happen? As recently as 2007, companies returned 100% of cash to shareholders (through buybacks and dividends), note analysts at J.P. Morgan. If we revisit that era, then “the $821 billion in total cash return (over the past four quarters) could increase by as much as 37% to $1.1 trillion if companies actually expanded total cash return levels,” these analysts note.
Frankly, either scenario is great for stocks. If the economy strengthens and capital expenditures get more attention, then they could trigger a virtuous cycle of spending across many industries. And if the economy doesn’t materially strengthen, then higher buybacks and dividends will sustain the appeal of stocks for many investors.
If you assume we should expect further tepid growth, and expect companies simply to continue focusing on buybacks and dividends, then it’s wise to identify the companies with the greatest financial flexibility to expand their level of buybacks and dividends.
The best measure is payout ratio (though I am using the term in this context to reflect cash spent on both dividends and buybacks). Many large companies aren’t far from that 73% ratio cited earlier, though you can still find solid companies for which this figure is below 50%, including:
1). Comcast Corporation (NASDAQ:CMCSA): 10%
2). The Walt Disney Company (NYSE:DIS): 16%
3). Time Warner Inc (NYSE:TWX): 35%
4). Union Pacific Corporation (NYSE:UNP): 39%
5). Honeywell International Inc. (NYSE:HON): 34%
Several of these companies have been actively on the acquisitions front, but if they don’t pull of any large deals in coming quarters and years, then appear increasingly likely to sharply hike their dividends, buybacks or both.
While many companies have been pumping up their cash balances, some of them have also largely avoided taking on any debt. But with stable cash flows and a stable economy, the time may be right to attain a higher level of debt leverage, which brings tax benefits, and could also fuel hefty buybacks and dividends. Here’s a short list of major firms that have fairly low debt-to-capitalization ratios.
1). Occidental Petroleum Corporation (NYSE:OXY): 16%
2). Visa Inc (NYSE:V): 0%
3). Public Storage (NYSE:PSA): 5%
4). T. Rowe Price Group, Inc. (NASDAQ:TROW): 0%
5). Mastercard Inc (NYSE:MA): 0%
Risks to Consider: Companies are buying back huge sums of stock even after the stock market has delivered huge gains. A sharp market pullback would lead to complaints that the high level of buybacks were done at the wrong time.
Action to Take –> Barring any sort of cataclysmic global economic meltdown, major U.S. companies are now laden with a sufficient amount of cash. In the years ahead, look for these shareholder return efforts to persist or even strengthen. That’s why it pays to assess any stock on your radar in terms of its potential to return cash back to shareholders.
– David Sterman
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