Below is an excerpt from a recent edition of Bespoke’s nightly Institutional note, The Closer.
One of the great complaints about the post-crisis equity market is that it is “propped up” via buybacks. However, buybacks are just one form of capital return (with dividends the other option). Firms with operating cash flow have limited options around what to do with it: hold the cash (which almost always has poor returns), reduce debt (which isn’t a very good strategy for most companies when real rates are low), invest in new production (again, a poor strategy in a world of relatively weak final demand growth), return capital (via dividends or buybacks) or, finally, purchase other businesses via M&A.
Given the buyback narrative, it may surprise investors to discover that 10% of S&P 500 assets are goodwill (that is, the asset recorded when a company is purchased above book value). The growth of goodwill represents a relatively aggressive acquisition strategy from major corporate CEOs, and frankly, it makes us somewhat nervous that 10% of all US equity assets (which themselves in aggregate are already being valued at 3.3x book value) are the remainder of acquisitions above and beyond the book value of assets.
Are companies really better-served continuing to accumulate these sorts of assets via acquisitions instead of returning capital to shareholders? As things currently stand, the 10% number is probably manageable, but we encourage investors to think critically when considering some of the alternatives implied by market memes similar to the complaints about buybacks. Sign up for Bespoke’s “2020” special and get our Bespoke Report 2020 Market Outlook and Investor Toolkit.