The Buybacks Aren't Working

Rate rises and inflation give CEOs an opportunity to invest.

Here's a sign it's time for CEOs to stop spending on buybacks and start reinvesting in their business.

Buybacks? No, Thanks

An index tracking European share buybacks is underperforming the broader market

Source: Bloomberg

The Solactive European Buyback Index, which tracks companies that have announced stock repurchases in the past two months, is down 1.9 percent since the end of September and is underperforming the broader European market.

This could be a blip -- over the past five years, companies that have repurchased stock have strongly outperformed -- but it may be an indicator this piece of financial engineering is becoming increasingly out of step with political and market realities.

Buybacks have been easy to justify financially in recent years thanks to record low borrowing costs, swelling cash piles and a weak economy bereft of attractive investment opportunities, especially in Europe.

Easy Money

Total value of shares repurchased by Europe's 200 biggest firms by market value

Source: Bloomberg

Europe's 200 biggest companies splurged $14.6 billion on buybacks last year, according to Bloomberg data. That's down from $19.7 billion in 2014 and $20.3 billion in 2013, but still a big number. For the first six months of 2016, the figure stands at around $6.3 billion.

Rather than encourage CEOs to spend on factories or products, efforts by central banks to flood the economy with cheap money have triggered a boom in shareholder-friendly financial engineering, with a reduced share count mechanically lifting earnings per share. That, naturally, helps CEOs to meet their bonus targets.

But the era of easy money is running out of steam. Next year will see more volatility, steeper rate curves globally and a shake-out in bonds that has already started, according to Deutsche Bank.

It's too soon to tell how bad the impact will be on big companies in Europe, where central banks are still buying corporate debt to keep borrowing cheap. But expect investors to bet on a shortening shelf life for QE, as well as on rising political risk from the elections in France and Germany.

Spending Starvation

Capital expenditure and research & development as a proportion of sales for Europe's 200 biggest firms

Source: Bloomberg data

That may encourage CEOs to hoard cash. But now would surely be a good time for them to put still-cheap cash to work by spending on expansion and innovation -- both of which have been starved in recent years.

The voter frustration that put Donald Trump in the White House and the U.K. on course to leave the EU is likely to put corporate spending in the spotlight, especially if governments dangle the carrot of tax cuts to boost economic growth. British Prime Minister Theresa May has stopped short of appointing workers to company boards but her criticism of the "privileged few" at the top of society remains constant.

Obviously nobody wants to see politics come before business logic. But it's fair to say, as former Goldman Sachs economist Jim O'Neill has done, that companies have become too beholden to financial metrics and balance-sheet efficiency.

Over-spending sometimes does make sense: an incumbent can protect market share by buying physical real estate or spending on new products that crowd out the competition, according to Giacinta Cestone of the Cass Business School in London. Companies may be being too conservative in calculating the beneficial impact of this kind of investment on future cash flow.

All of which takes us back to that first chart. If CEOs are spending money on buybacks instead of preparing for an increase in borrowing costs and a pickup in inflation, that may quickly start to look misguided to investors.

Marks & Spencer Group Plc last year announced a 150 million-pound buyback -- a move that looks wrong today given its recent announcement of store closures and spending on food outlets. LVMH's recent buyback was described as small and "almost useless" by Bryan Garnier & Co. analysts -- but it's still 300 million euros.

Expect to see investors pushing for a shift into spending gear.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    Lionel Laurent in London at

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