Stock Buybacks: The Battle of Perception vs Reality
Recent years have seen growing popularity in share buybacks, the process whereby a company repurchases outstanding shares of its own stock. The argument is that when lacking better investment opportunities, companies should return capital to shareholders, reduce share count and that will ultimately support the stock price. Buybacks are catching the attention of politicians as well. There are concerns that companies are not spending a sufficient amount on employees or reinvestment in projects that would be beneficial to the broader economy. In this discussion, we take a look at the growth in buybacks, the ramifications for investors and address the concerns raised by politicians (such as this op-ed from Bernie Sanders and Chuck Schumer).
There are two mechanisms for companies to return capital to shareholders – dividends and share repurchases. There was historically a preference for dividend payments for a number of reasons, but the past 10 years saw the continuation of a paradigm shift towards buybacks. In fact, companies in the S&P 500 Index repurchased more than $4.7 trillion of their own shares during that time, vastly outpacing dividend payments.
On an absolute basis, that number sounds enormous, but maybe even more surprising is that it recently accelerated. With corporate tax rates declining after 2017, companies had additional cash on hand and there were 444 companies within the S&P 500 Index that repurchased shares in 2018. In total, those companies repurchased $806 billion worth of shares.
Only looking at the absolute dollar value of buybacks lacks an important element of context as the stock market itself has performed well over the same period of time. With the aggregate value of companies having risen it is necessary to consider buybacks as a percentage of total market capitalization. On that basis, buybacks as a percent of market cap look quite ordinary. In fact, buybacks were lower in 2018 than in 2007.
Given the dollar amount spent on buybacks in 2018 and the perceived lack of economic growth, politicians have begun to voice their concerns. Those concerns are outlined below, but in general they are centered on the idea that companies should not only reward shareholders. It is thought that they should reinvest in employees, reinvest in things like technology and the result would be a multiplier effect that filters through to the economy. Let’s explore the criticisms.
Legality: buybacks were “illegal” prior to 1982. It is not clear that they were explicitly illegal, but the Securities Exchange Act of 1934 prohibits security price manipulation. The definition of what constituted manipulation is not cleanly defined and it was implicitly accepted that buybacks were a form of manipulation. But in 1982, Congress passed a new rule providing legal protection for companies seeking to repurchase shares. Some argue that ipso facto, buybacks were illegal previously and they should be illegal again.
Unrealized economic potential: capital spent on buybacks should be diverted to higher employee compensation, research and development, and capital expenditures, thereby supporting the broader economy.
This criticism implies that companies should always reinvest back into the business. Doing so is not always productive (see next bullet: value destruction). If investing in a project results in a higher expected return than it costs to finance that project, then yes companies should pursue that endeavor. If companies are reinvesting in those projects irrespective of expected return, poor investments may result. It is the job of company management to determine most appropriate capital allocation, whether that is returning capital to shareholders through dividends/buybacks or reinvesting internally to generate returns.
Value destruction: companies such as General Electric conducted more than $40B in buybacks between 2015-17 at share prices ranging from $20 to $32. Move forward two years and the stock was trading below $10. Wasn’t it destructive to spend so much money on buybacks as opposed to reinvesting in the business? Not exactly. GE is an isolated situation not indicative of all companies. Given the lackluster history of investment by that specific management team, simply reallocating that money to purchasing other businesses or research & development may have been equally as futile.
Indebtedness: there is concern that companies are borrowing money in the current low interest rate environment to fund repurchases. In our opinion if that were true, it would be a reasonable concern. In reality, the largest percentage of buybacks have occurred in sectors such as technology (25% of all buybacks in the past decade) and healthcare. Those are not heavily indebted sectors. If we look at the largest corporate repurchases, the list includes Apple, Facebook, Alphabet, Oracle, Microsoft, IBM, Visa. Again, not heavily indebted companies.
Incentive misalignment: companies may borrow money to boost short-term earnings per share (note: share repurchases reduce the share count which can theoretically makes earnings per share appear higher). Management team compensation may increase if short-term financial objectives are met, such as achieving certain levels of EPS. In our opinion, this is as much an assessment of management team capability as anything. If a particular management team is operating under selfish motivations, there is a reasonable likelihood the share price should reflect that information.
There are a few ongoing implications. Investors have historically relied on companies to determine the best capital allocation procedures. Management could reinvest in corporate projects if a sufficiently adequate return were achievable, they could pay dividends, or they could repurchase stock. The preference in the recent environment has been to maintain dividend payments at a steady rate while increasing share repurchases. Share repurchases provide flexibility in that repurchases can be stopped relatively easily if other capital needs arise. Companies are more hesitant to reduce dividend payments, viewing that as a stable approach to capital distribution. Investors should recognize that share buybacks are one piece of a broader capital allocation policy undertaken by company management.
Michael Mauboussin synthesizes the concerns around stock buybacks as such “A company should retain its earnings if it can earn a rate of return that is above the cost of capital. But if shareholders can earn a higher rate of return on capital than the company can, the company should disburse the cash.”
We understand the desire to bring stock buybacks into the political sphere. There are valid criticisms of particular company’s ineptitude related to poorly timed buybacks and poor spending decisions. Those situations are not endemic of a broader societal problem around buybacks, however. Those are company specific situations that arise from management teams making incorrect decisions. As always, we encourage everyone to arrive at their own conclusions, but we generally view the politicization of stock buybacks to be unjustified.