If you are sitting in the board of directors of an American public corporation or you are a member of the management team, you already know that corporate stock buybacks are a publicity scheme. It is a great way to attract attention to your stock to get more buyers, because who doesn’t like free money? This is exactly what happens when a company announces a stock buyback and devotes a large chunk of its cash to buying back stocks. This then boosts the stock price as more investors buy in, hoping that the stock will appreciate and they can cash out at a profit.
The company is able to do this because it can devote its available cash to buybacks and borrow operating capital at very low interest rates. It’s a win-win situation, right? Not so fast. The problem with this is if a few companies engage in this scheme, it can pass. However, if all companies or a lot of public companies do this, it can pose a tremendous moral hazard on corporate health. It only takes a relatively short but sustained period of economic downturn to destroy this house of cards.
Unfortunately, this corporate habit is a very difficult habit to break. It is like discovering how to artificially pump up the price of your stocks and now being told not to. It has been such a slam dunk in the past and you are frustrated that you are being told not to do it anymore.
You have to understand that many corporations now are operated like hedge funds. They are in a constant search for higher and higher rates of return. This is why such stock inflation schemes are so popular on Wall Street. It appears that there is no downside. It only looks like there is no downside if everything remains the same. Unfortunately, you cannot say that. There will always be uncertainties down the road and it is only a matter of time until the wrong kind of bad news makes the rounds and we all have to pay the piper.
