Goldman Sachs to CEOs: Stop Buying Back Stock. Buy Companies Instead.

Goldman Sachs Group Inc.GS +0.82% analysts have a message for chief executives who are buying back their company stock: Stop it. Stop it this instant.

U.S. equity valuations look expensive by “almost any measure,” they say in a new research report. Instead of spending money to buy overpriced shares, the team from Goldman argues, executives should use their soaring stocks to buy up other companies.

But the analysts aren’t exactly confident any corporate chieftains will listen to their plea. That’s clear from the very start of their research note, titled “What managements should do with their cash (M&A) and what they will do (buybacks).”

Goldman portfolio strategy analyst David Kostin and his colleagues write that corporations, like investors, don’t have a good track record in timing the market. In 2007, they noted, corporations used more than one-third of their cash to buy back stock right before the S&P plunged by 40%. At the bottom of the market in 2009, they spent just 13% of their annual cash on repurchases.

The Goldman team predicts that corporations will mimic what they did in 2007 this time around. They forecast that buybacks will surge by 18% in 2015 and will account for nearly 30% of cash spending. Some of the impetus for executives to repurchase shares comes from activist investors pushing for firms to do so, he said.

Goldman contends that spending on buybacks now is ill-advised given that stocks are “expensive on most metrics.”  The S&P 500 index, they write, is trading at a multiple of 18.1 times its forward earnings, which is in the 98% of its historical valuations since 1976.

“In our view, acquisitions – particularly in the form of stock deals – represent a more compelling strategic use of cash than buybacks given the current stretched valuation of U.S. equities,” they write.

While U.S. announced M&A volume is at its highest level on record, up 57% from a year ago during the first five months of the year, Mr. Kostin and his team said that corporations overall have used record profits to return cash to shareholders through more than $2 trillion worth of buybacks over the past five years.

Mr. Kostin does think that in the near term, stock buybacks will be positive for the performance of stocks. “Most firms should do something with their cash other than buyback shares. However, we expect firms will repurchase shares and investors will reward these actions and shares will post near-term outperformance.”

[“source-blogs.wsj.com”]