Companies Look to Own Shares for Investment

American companies seem to have discovered what good investments their own shares can be, and this realization may be helping to keep the stock market afloat.

The amount of stock removed from the market has been rising of late due to mergers, acquisitions and, especially, corporate share buybacks.

Fueling the trend has been robust profit growth and a new psychology among executives to boost shareholder value not by expanding operations or paying dividends but by shrinking the number of shares outstanding.

“Money is accumulating because many companies are enjoying record profits and generating more earnings than they can prudently invest in additional facilities, equipment and personnel,” reads a recent shareholder report from portfolio managers at Janus Funds of Denver.

Shares removed from the market exceeded the amount added by new stock offerings by $135 billion during the first half of 1995, according to numbers compiled by Goldman Sachs and reported by Janus. That compares with a previous record shrinkage of about $120 billion for all of 1988.

“The fact that lots of share repurchases are taking place indicates that managements feel their companies are good investments,” says Warren Lammert, who runs the large-stock Janus Mercury Fund.

That in itself sends a bullish signal to the market. But reducing the number of shares directly increases the value of each remaining share, since earnings per share are higher. Also important, it shows that management is less willing to funnel excess cash into new, often unrelated businesses, as during the conglomerate craze of the 1950s and ‘60s.

“For companies in a slow-growth business, one of the best ways to grow earnings may be to reduce shares,” says Michael Jones, manager of the Clover Capital Equity Value Fund in Pittsford, N.Y.

The buyback trend also helps to explain why dividend yields, at 2.3% for the stocks in the Standard & Poor’s 500 index, are so low.

“Dividends make little sense in a world of double taxation,” Lammert says. That’s especially true with top dividend tax rates of 39.6% so far ahead of the 28% rate imposed on capital gains.

The tax reasons alone make some higher-income shareholders prefer that the company buy back shares than pay dividends.

“The market looks significantly more attractive if you look at the dividends paid plus the amount of money in share buybacks,” says Lammert, who says he remains positive on stocks today.

The emergence of a share-buyback psychology might help to bolster the market during bearish phases. The announcement by dozens of companies that they intended to repurchase stock during the depths of the October 1987 crash probably helped to shore up sentiment and stem losses.

But it’s worth noting that the supply of stock hasn’t been shrinking across the board. Large companies are more likely to repurchase shares than small firms, which often have erratic earnings and typically must funnel all profits back into the business to keep it growing. It might even be unwise for a small, growing firm to divert capital from future expansion by repurchasing shares.

The implication for mutual fund investors is that the share-buyback theme is more likely to be played by managers of equity-income, growth and growth-and-income funds--all of which focus on larger stocks--and less so by those in the small-company or aggressive-growth camps.

Not everyone attaches the same significance to the buyback theme. One skeptic is Richard Howard, manager of the T. Rowe Price Capital Appreciation Fund in Baltimore, who doesn’t think the supply of shares generally is that critical in explaining a rising or falling market. But even he agrees that in certain cases--as in the situation of an undervalued company run by the same family-dominated management team for years--a buyback can help boost the share price.

“Those fuddy-duddy managements tend to be pretty shrewd when it comes to share repurchases,” he says.

Against the backdrop of the share-buyback theme is the somewhat worrisome trend of an upsurge in new stock offerings, which obviously increase the number of shares available. Initial public offerings rose from 18 in January 1995 to 81 in November and 75 in December, says Barbara Walchli, director of equity research at First Interstate Capital Management, which runs the Pacifica family of mutual funds in Scottsdale, Ariz.

“Historically, when the number of IPOs exceeds 70 in a month, the stock market for the next six to 12 months tends to post neutral returns of 5% or less,” she says.

But Walchli says she’s not as concerned about the high IPO volume as she normally might be because the U.S. economy is sluggish right now, interest rates are under control and money--in a word--is so plentiful.

“There’s so much liquidity sloshing around the system” that the IPO volume has been absorbed relatively easily, says Walchli, who nevertheless sees a rough first half in 1996 because of slowing corporate profits.

*

The Acorn and Acorn International Funds of Chicago have reopened their doors to new shareholders.

The international portfolio had been closed since early 1994, while Acorn itself, a small-company product, had been unavailable since 1990. Both enjoy above-average ratings from Morningstar Inc. of Chicago. Portfolio Manager Ralph Wanger reports finding excellent values in European stock markets.

The funds ([800] 922-6769) don’t carry a sales charge, but they do impose a redemption fee of 2% on shares held less than two months. Morningstar reports that the number of diversified stock mutual funds able to beat the unmanaged Standard & Poor’s 500 index dropped to just 16% in 1995--the lowest percentage in 20 years of tabulation. The S&P; 500 has outperformed stock funds generally in 10 of the last 13 years.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Spending Excess Cash

Here’s a look at how corporations have tended to make use of capital that hasn’t been needed in the core business:

* 1950s and 1960s: Companies in slow-growing industries acquire other, often unrelated businesses.

* 1970s: The conglomerate craze slows as interest rates skyrocket, making it much more costly to acquire other businesses with borrowed money.

* 1980s: The process of consolidation begins with a recognition that a company’s parts may be worth more than the whole. As interest rates fall, takeover specialists use junk bonds to launch leveraged buyouts of undervalued companies, removing a large amount of stock from the market.

* Early 1990s: Indebted companies focus on putting their balance sheets in order.

* Mid-1990s: Corporate competitiveness and profits improve as a result of downsizing, automation, a weak dollar and other factors, and many companies repurchase shares, helping to bolster stock prices.

Source: Janus Funds