Governments have a habit of spending more than they earn because that's the simple formula for politicians to get re-elected.  Making promises to voters helps win elections.  This simple reality has been taken to extremes in some European counties known as PIIGS (Portugal, Italy, Ireland, Greece, and Spain).  Now there are rumblings of governments defaulting on thier debt and this has caused stocks markets to fall.  In the short-term, falling stock markets are bad for investors, but what about in the long-run?

 

For the kinds of companies I own, even if I am not buying more shares, bad stock markets add wealth for me over time.  Why?

 

First off, I tend to invest in dominant companies that have been in business for decades and have successfully weathered recessions and other adversity.  These companies usually offer products people need and use in good times and bad.  In additon, these companies are mature, so they tend to earn excess cash in addition to their regular dividend payments.  With this cash, they will often buy back their own shares.

 

I could use any number of companies that I own to explain this idea, but let's take a quick look at ExxonMobil (because the annual report is right in front of me).  This company is the largest privately owned oil company in the world and offers a way to profit from the long-term economic growth the world should experience in the coming decades.  If I look at the financial statements, I see that Exxon spent $27 billion on capital and exploration expenditures while spending another $26 billion on dividends and share buybacks - and last year was not a great year for this company.  In total around $19 billion was used to buy back the company's own shares last year.  What does this mean?

 

As a simple example, suppose you own a business along with 9 other people.  Every year, the company uses its profit to buy the interest of one of the partners such that there is one fewer partner every year.  In this situation, after only 9 years all the other partners would have been bought out and you would own the entire company!  Think about it, even if the company had not grown at all, you would have gone from only owning 10% of the company (10 partners) to owning 100% of the company.  This is the same thing companies are doing when they buy back their own shares - your percentage ownership in the company increases.

 

If Exxon continues to buy back their own shares, they will buy many more shares if the stock price is lower.  Simply put, if they repurchase 5% of their outstanding shares at a stock price of $60 per share, they would repurchase 10% of the the shares if the stock prices drops to $30.  Within Exxon, there would still be just as much oil and gas in the ground, but each shareholder would own more of it if the stock price declines!  So bad markets create wealth for long-term investors.

 

Here is a quick list of some of the companies I own that regularly buy back some of their own shares: Coca-Cola, CR Bard, Johnson and Johnson, Imperial Oil, Phillip Morris International, ExxonMobil, WalMart, and Dun and Bradstreet.