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Analysis: In U.S., 'animal spirits' remain leashed as cash flows to shareholders

A model of the 787 Dreamliner is seen at the welcome center for South Carolina Boeing in North Charleston, South Carolina December 19, 2013. REUTERS/Randall Hill

By James B. Kelleher and Jennifer Ablan

CHICAGO/NEW YORK (Reuters) - It's official: 2013 will be the second-biggest year in history for U.S. corporate share repurchases, though the "shareholder friendly" moves are beginning to give some economists and investors the jitters.

Just this week, 3M (MMM) and Boeing (BA) alone authorized as much as $32 billion in repurchases, jumping on a bandwagon that has already attracted nearly 500 U.S. companies, including industry leaders like Microsoft Corp. (MSFT), General Electric Co. (GE) and Wal-Mart Stores Inc. (WMT).

The repurchases, and a related surge in dividend payouts, represent a victory for shareholder activists and a short-term bonanza for investors.

But they also trouble some observers.

David Rosenberg, chief economist at Gluskin Sheff, worries the repurchases are siphoning money away from other more productive investments that companies should be making at this period in the business cycle, such as capital goods, technology, acquisitions and employees.

In the first three quarters of 2013, U.S. companies have invested $433 billion on machinery, plants and software, according to Howard Silverblatt, senior index analyst at Standard & Poor's.

While that's up from $416.2 billion they spent on capex in the comparable period in 2012, it's about half of what they've spent on buybacks and dividends this year.

The cautious use of cash could come back to haunt U.S. companies - and leave them looking flat-footed - if the economic recovery begins to gain speed and confidence in 2014.

That's a scenario that looks increasingly likely following Friday's upward revision of U.S. third-quarter gross domestic product numbers. The Commerce Department said the U.S. economy grew at a 4.1 percent annual rate in the third quarter, its best showing in almost two years and up from a previous estimate of 3.6 percent.

Time Warner Cable (TWC.N) provides a timely illustration of the dangers that come when a company focuses on financial engineering rather than business development and innovation.

Its stock price has increased more than five-fold and it returned more than $9 billion to its shareholders in dividends and stock buybacks, but the nation's second-largest cable operator has become one of the industry's weakest performers and is seen as a takeover target.

Rosenberg, who has had a reputation for bearish calls over a decade but is now optimistic about the U.S., said the current environment with its flurry of buybacks is "one of the weakest investment cycles ever", and says that productive investments are a key "missing link" in the economic recovery.

Data from FactSet supports Rosenberg's take. Capital spending by non-financial companies in the S&P 500 is expected to rise just 3.8 percent in 2013, according to the financial analytics firm.

Capital spending rates can swing widely from year to year. But this year's paltry forecast increase in spending on new machines, facilities and IT is well below the median annual growth rate of 10.5 percent since 2007, according to FactSet.

Then there are the fears the activity could be a warning sign the high-flying stock market is headed for a correction.

The last time repurchases reached this level was in 2007, according to Thomson Reuters data, right before the stock market crashed.

"Companies are generally not very good at timing their buybacks," says David Santschi, the chief executive officer TrimTabs Investment Research.

But Santschi says that track record should not come as a surprise. The purpose of most repurchase programs, he says, is to offset the effect of insiders dumping their shares while stock prices are high.

"Companies aren't buying back stock because they're great market timers ... They're not trying to outperform market averages. They're buying back stock to reduce or eliminate dilution. So they don't buy as much when stock prices are low."


So far this year, nearly 500 companies have pledged to buy back $475.4 billion of their own shares, according to Thomson Reuters data. That's the second-largest flurry of repurchases ever, according to Thomson Reuters, and the largest buyback since 2007, when they bought back $623 billion in shares.

America's biggest companies are also on track to pay out another $310 billion in dividends - an all-time record, according to Howard Silverblatt, senior index analyst at Standard & Poor's.

The moves have helped fuel a rally on Wall Street and, by reducing the number of shares outstanding, are lifting the reported earnings-per-share of the companies making the repurchases.

But some experts question whether those payouts, especially the buyback authorizations, really represent the best use of corporate cash - especially when many shares are near record levels.

"It is always odd to see buybacks picking up when the market is at all-time highs," said Paul Hickey, co-founder of Bespoke Investment Group.

"After all, if the insiders are so plugged in to their companies, wouldn't they buy when prices are low?"


Ordinary shareholders are benefiting from the repurchases, for sure. But so too are corporate executives whose compensation is tied to an earnings per share metric. By reducing the number of shares in circulation, buybacks have the effect of making reported EPS rise -- even if profits are stagnant.

The buyback boom could also help executives by creating favorable conditions for them to sell shares they receive as part of their compensation. And in fact, "insider sales" have been on the rise lately.

TrimTabs says that based on its analysis of Form 4 filings with the Securities and Exchange Commission, insiders sold $7 billion of their holdings in November. That was the highest level of insider sales seen since May and a 40 percent jump over the five-year average of $5 billion a month.

Who else benefits from buybacks and the stock rallies they help fuel? Short-term investors, who are playing a big role in the current rally on Wall Street.

Jack Ablin, the chief investment officer at BMO Private Bank in Chicago, points out that margin debt - a gauge of the level of speculative activity in the stock market - is at an all-time high, surpassing the 2000 and 2007 peaks and that such peaks have "historically corresponded to stock market peaks."

(Editing by Christian Plumb and Chizu Nomiyama)