Innovations And Rising Stock Prices

August 18, 2014


Innovations like float adjustment help indexes better represent market returns, while innovations in stock selection and index weighting create indexes that allow investors to take advantage of different risk factors and investment approaches. Some indexes would be more transparent, however, and the investment products tracking them perhaps less expensive, were it not for innovative ideas companies sometimes use to boost their stock prices.

In most investment theories, one way for a company to make its stock attractive is consistent earnings and dividend growth. Yet even when earnings grow, and certainly if they stumble, companies often try other ideas to attract investors. Buying back stock or paying special dividends are common examples. Pitching for particular sectors or lobbying for index membership are others. Larger efforts can include changing legal incorporation. Further, some mergers and acquisitions are motivated by financial engineering rather than business opportunities. Whether or not any of these raise stock prices, they all challenge index management, reduce transparency and potentially cost investors money. Some new developments in indexes depend on index providers’ creativity; others stem from the necessity of dealing with games of corporate finance.

Buybacks And Dividends
One popular approach is buying back stock; buybacks are currently at record levels. Companies typically announce buyback programs extending forward for a quarter or longer. The results are revealed in subsequent SEC filings, and then indexes adjust share counts and ETFs complete the necessary trading. The message the company wants to send to investors is that the stock is a good buy, but there may be other messages. First, not all buyback programs are completed as planned, so the actual change in shares could be less than what was initially announced. Index providers must base their adjustments on the results, not the predictions. A bigger issue is the company’s motivation—in many cases, the buyback follows a large issuance of new shares required for employee stock options being exercised after a sustained rise in the price. The buyback absorbs the recently issued shares and limits dilution of the stock. While limiting dilution is beneficial for current shareholders, the impetus for the buybacks was past stock price increases, not management expectations for future gains.

Dividends, especially increasing dividends, make stocks attractive. However, one sure way to send a stock price straight down is to cut the dividend. Each time a company initiates or raises its regular dividend, management knows that if the new level cannot be sustained, the stock will pay a heavy penalty. One answer is to issue a special dividend—one that does not include a promise for the future—instead of increasing an ordinary dividend. This makes sense if some unique event—a divestiture—leads to a cash distribution. Some companies issue special dividends fairly often so they don’t face having to cut their dividend if business is poor. Indexes usually include ordinary dividends in total return calculations but treat special dividends as a return of capital and adjust the index divisor. When companies are less than transparent about their dividends, investors are left to guess, while index providers must decide what the dividend really is.



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