Budget Basics that could Benefit Individuals and Governments Alike

With U.S. government debt at record levels and a large tax cut recently announced while corporate profits are soaring, I often reflect fondly on the movie “Dave,” starring Kevin Kline. The movie warms my heart because it shows us what could be – within the realm of government budgets (and politics). While I’ll leave the political commentary to someone else, I will say that politicians and our government could benefit from a return to budget basics.

In the movie, the White House Chief of Staff decides to use a stand-in for the President during a public photo opportunity. Things get interesting when the actual President suffers a massive stroke at the time of the publicity event. Looking to hold onto power, the Chief of Staff has the Presidential double, a small business owner named Dave, continue to fill the Commander in Chief’s shoes. While Dave has a big heart and a do-good attitude he also starts to use his new-found power. He first tests these waters by calling his friend and accountant Murray to the White House to review the annual budget. After reviewing the government ledger, Murray declares that if “[he] ran his business this way, he’d be out of business.”

There’s no doubt that the U.S. financial system is a much more complicated structure than an individual household or small business, but as the movie “Dave” suggests, it can still benefit from the simple principles you and I use regarding our own financial affairs. One such principle is debt management. As it stands, U.S. debt to gross domestic product (GDP) is around 105%. Gross domestic product (GDP) is the total dollar value of all goods and services produced over a specific time period. While GDP is a measure of the size of our economy it also describes how much the U.S. produces or earns.

The point is that a higher GDP (i.e. earnings) suggests the government can handle higher debt levels. The same principle applies to an individual: someone with a larger salary can typically handle a higher level of debt, all else equal. But when you divide debt by income or GDP – the debt to GDP ratio mentioned above – lower is usually better. For example, most banks will consider an individual a high credit risk if their total debt level to gross income is above 36%. Now compare that to 105% of U.S. debt to GDP and you can see that our government might do well to start reducing its reliance on debt.

Looking at the historical record, U.S. debt to GDP has averaged 62% since 1940. Today’s levels are well above that and the second highest in our history. Debt to GDP reached an all-time high in 1946, at 119%, when the U.S. issued a significant amount of debt to fund our efforts during World War II. Given the serious threat to world stability during the 1940’s, most would argue the additional debt issuance was a risk worth taking. However, today’s elevated debt levels come during a time of relative peace and following nine years of U.S. economic expansion – the second longest on record.

Shifting back to budget basics, most would agree that times of prosperity and stability are ideal periods in which to reduce the deficit and thus national debt. Or at least not add to existing levels.  Unfortunately, the U.S. government has not followed these principles in recent years. Granted, we’ve had some extenuating circumstances such as the Financial Crisis but we’ve also had steady if not subpar GDP growth since then. Most economists – and budget basics – would argue for increasing taxes or at least holding them steady towards the later innings of an economic expansion, when corporate profits are high. However, this time around Congress passed a tax bill that significantly reduced company taxes.

To be fair, there are well documented benefits to running a budget deficit (for a country) and cutting corporate taxes. However, if deficits continue over the long-term, debt levels can mount, ultimately becoming a headwind to future economic growth and prosperity. As interest rates climb from currently depressed levels, so will debt servicing costs. On top of higher interest expense tied to rising yields, the historical record has shown that large tax cuts can boost inflation – especially when implemented towards the end of an economic expansion – and thus contribute further to rising interest rates. At the same time, lower taxes reduce the government’s revenues and make weathering the next recession more difficult.

While the recent tax bill is clearly a near-term positive for companies, employment, and the economy, it can also bring long-term benefits if our politicians implement sound financial policies that balance the budget and bring down government debt levels. In short, our Congressional and Executive leaders might do well to take a page out of the movie “Dave” and return to some budget basics. They might also enjoy a little break in the process.

 

 

 

 

 

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Why Stock Buybacks are Significant and What to Make of Recent Trends

Company stock buybacks recently surpassed 2007’s prior record of $172 billion. As of the first quarter 2018, buybacks from the S&P 500 Index constituents reached $178 billion, up about 34% year-over-year. This compares with $24 billion in stock buybacks at the market bottom in 2009.

As the name implies, stock buybacks (also known as share repurchase programs) happen when companies buy back their own shares. A firm uses its cash position to repurchase company stock either in the open market or directly from select shareholders. These programs reduce the number of shares outstanding for the company in question and thus increase the ownership stakes of its remaining shareholders. The end result is more profits or earnings per share (EPS) per shareholder.

In general, stock buyback programs are viewed favorably by Wall Street. These programs help neutralize shareholder dilution that comes from excessive stock option issuance. Many management teams go further and announce buyback programs that more than offsets dilution from stock options.  In these cases, existing shareholders see their ownership stakes grow, and with it, their portion of earnings per share.

Another positive attribute of share buybacks is their affect on key company financial metrics such as earnings per share (EPS), return on equity (ROE), and earnings growth rates. These ratios are used by professional investors to determine the health of a company and are usually part of their investment decision process. Because share buybacks often boost a company’s financial profile, these programs can lead to more interest among institutional investors and thus increased demand for the stock. Higher demand from large investors typically translates into a higher stock price. With higher ownership stakes and larger earnings per share accruing to remaining investors, stock buybacks offer shareholders a compelling, two-fold benefit.

Investor perception also plays a significant role in share buybacks. Many argue that because a company’s management team has inside information regarding a firm’s growth prospects, a share buyback announcement is a signal that a stock may be undervalued – otherwise management would choose to spend the company’s cash on more profitable investments. This positive signal alone can cause a stock’s price to rise.

There is a downside to share buybacks, however. In recent years, record-low interest rates have prompted many companies to issue large amounts of debt to fund their share buyback programs. While this has had the effect of boosting near-term earnings growth and increasing existing shareholders’ ownership stakes, it could come at the cost of longer-term returns. Although interest rates remain low, as yields increase- debt servicing costs are likely to rise. These higher debt burdens – taken on to buyback company shares – could crimp a company’s ability to invest in value-enhancing initiatives such as technology investments or new manufacturing facilities, and ultimately reduce long-term earnings and cash flow growth.

Likewise, stock buybacks are a more flexible alternative than issuing a dividend. Many contend that management teams prefer share repurchase programs to dividend payments because they can easily suspend buyback activity with limited negative ramifications. In contrast, dividend cuts are viewed quite unfavorably by investors and are likely to significantly pressure a stock price. When a company issues a new dividend it suggests confidence in the firm’s market position, growth prospects, and cash flows. Thus, when dividends are cut or eliminated it signals deteriorating company fundamentals ahead.

Given the short-term benefits and minimal near-term risks associated with share buybacks, more companies are engaging in these programs than ever. Similar to individual investments, repurchase programs are most beneficial when a management team buys its firm’s stock at low levels and watches it appreciate in value over time. Although the investing principle of buy low and sell high is well understood, many corporate directors fail to follow this basic rule of thumb. The historical record indicates that seasoned company management teams are just as likely to buy at peak valuation levels and refrain from share buyback programs at market bottoms.

Although company management teams have a poor track record when it comes to timing share buyback programs, many are excellent stewards of their firm’s growth prospects and market positions. This suggests that as individual investors we would do best to focus on high-quality investments with long-term track records of delivering value and leave the market timing to speculators.

Carrie Tallman, CFP®, CFA™
Guest Contributor 
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