Fueled by the Tax Cuts and Jobs Act, 2018 was a bonanza year for stock buybacks. According to numbers from Standard & Poor’s, U.S. companies repurchased $806.4 billion of their own stock last year, up 55% over 2017. Buybacks accounted for the lion’s share of the $1.23 trillion (35% more than the year prior) that issuers returned to shareholders.|
Over a longer period, the numbers are staggering. Since 2009, S&P 500 companies have repurchased $4.7 trillion worth of shares. That’s about the size of the entire exchange-traded fund industry. That much money flowing back into shareholders’ pockets through buybacks has not gone unnoticed. Hot debate rages on as to whether this is good business practice, or whether buybacks are simply feathering the nest of corporate executives at the expense of the economy as a whole.
According to a joint statement by Sens. Chuck Schumer of New York and Bernie Sanders of Vermont, “when a company buys back its stock, boosting its value, the benefits go overwhelmingly to shareholders and executives, not workers.” Furthermore, “when corporations direct resources to buy back shares on this scale, they restrain their capacity to reinvest profits more meaningfully in the company in terms of [research and development], equipment, higher wages, paid medical leave, retirement benefits, and worker retraining.”
Clearly the discussion has evolved (or devolved) into the realm of political populism. But the question is still worth asking: Do share buybacks make economic sense?
Gregory Milano, CEO and managing partner of Fortuna Advisors, argues that Schumer and Sanders are off-base. “By failing to see how such payouts to shareholders increase capital productivity, the senators have misunderstood the critical economic function of them,” he says. Buybacks recycle “excess capital” from large, mature companies with fewer investment or employment opportunities to “the next generation of Apples and Amazons,” he adds.
Why do companies repurchase stock in the first place? Dr. Howard Johnson, managing director at Duff & Phelps, explains one of the big drivers for the massive repurchases: they are a low risk way of getting rid of too much cash on the balance sheet.
“Many schools of thought suggest that cash on the balance sheet gets discounted by the market, because it may cause inefficiencies on the part of management, or may signify the company simply can’t find adequate alternative uses of capital,” Johnson says. “Where managers aren’t willing to put excess cash to work in the company’s own growth initiatives or acquisitions, they find that the best return is through the repurchase of outstanding shares.”
Another reason for acquiring outstanding shares, Johnson adds, is to signal that the company’s shares are undervalued. “By repurchasing stock, management is hoping to demonstrate to the market that it believes the value of its shares will rise over time.”
There is also evidence to suggest that companies with lots of cash on their books are more likely to be takeover targets. At small- and mid-cap firms, says Johnson, management will sometimes buy back stock to defend against takeovers.
As to why companies prefer to boost shareholder value by buying back stock rather than raising dividends, “dividends are longer-term commitments for the company, and if you eventually need to decrease the dividend that sends a very negative signal to the market,” Johnson notes.
Few would dispute that the reasons Johnson lists are indeed motivations for stock buybacks. But there may be others. Some experts suggest that short-termism is the primary driver behind stock repurchases, as managers time them so that their companies meet earnings expectations.
In his most recent study on the topic of earnings manipulation, Ahmet Kurt, professor of accounting at Suffolk University in Boston, found that 14% of the companies undertaking regular stock buybacks on the open market from 2004 to 2011 would have missed analysts’ earnings-per-share forecasts had they not repurchased stock. That figure is even higher, 29%, among firms engaging in accelerated share repurchases (ASRs), which are completed much more quickly (a few days) than open-market buybacks.
Despite the potential use of buybacks to temporarily meet short-term profit targets, they could still be a good investment. But are they, at least in terms of driving shareholder value? Have shareholders benefited when companies repurchased stocks?
In the last year to April 1, 2019, the answer is no. When compared with the performance of the S&P 500 overall, year-over-year performance of the 100 stocks with the highest buyback ratios in the S&P lagged by more than 3%. Although that is not truly an apples-to-apples comparison, it does support much of the criticism that this year’s massive buybacks were a bad investment for companies that ultimately left shareholders worse off.
The argument that a share buyback is a good investment, at least from the perspective of a boost to the share price, is flawed to begin with, says Kurt. “It’s very difficult, even for the company’s executives, to predict the movements in a company’s stock price,” he says.
Kurt points to Apple and Wells Fargo as examples. Apple repurchased 29 million of its shares in September 2018 for an average price of $222 per share. Three months later, the company’s stock was trading around $150. “So, in hindsight, Apple’s buyback does not look like a good investment,” Kurt says. Similarly, Wells Fargo bought back 26.6 million shares at an average price of $61 in February 2018. But, the company’s stock price fell below $45 in December 2018. As of April 1, neither stock had recovered.
If companies were acting in the best interests of their shareholders, adds Johnson, they would execute buybacks differently. “Any rational CFO would compare the economic return on the share buyback against other possible uses of cash and time the repurchases accordingly,” he insists. Unfortunately, in practice this hasn’t been the case.
To track buyback performance, Fortuna Advisors has developed what it refers to as “buyback ROI.” The metric can be used to compare returns on buybacks with returns on capital spending, acquisitions, and other investments. Buyback ROI measures the annualized internal rate of return based on the cost of buybacks, the avoided dividends, and the price of the repurchased shares at the end of the period.
In its 2018 study of the buyback ROI of a sample of S&P 500 companies, Fortuna found that three of every four companies mistimed their repurchases over the prior five years. They did this to such an extent that their buyback ROI was below their total shareholder return.
“Companies tended to buy back their shares closer to the peaks than the troughs,” explains Milano. “This failure to time buybacks more judicially reduces the benefit of buybacks to the remaining shareholders.”
Who is ultimately benefiting from buybacks then? Kurt leans toward the argument that senior company executives are the big winners. He notes that repurchasing stock offers them two main benefits.
First, it lifts the stock price in the short run, enhancing the value of executives’ stock and option holdings. Second, it helps increase their cash payments, because many executive bonus plans have EPS performance targets as a payout criterion.
Commissioner Robert Jackson of the Securities and Exchange Commission tends to agree. In a March 2019 letter to Democratic Senator Chris Van Hollen of Maryland, Jackson commented, “If executives believe a buyback is the right thing to do, they should hold their stock over the long term.” In referring to a study by Jackson’s office of all buybacks between January 2017 and the end of 2018, Jackson said, “we found that many executives use buybacks to cash out. That creates the risk that insiders’ own interests—rather than the long-term needs of investors, employees, and communities—are driving buybacks.”
Jackson went even further. He suggested that stock performance is even worse when insiders sell their shares upon the announcement of a buyback, concluding that “when executives sell into a buyback, the buyback is more likely to produce a short-term stock-price pop than a long-term, sustainable value increase.”
According to Jackson’s study, 90 days after buyback announcements, firms with insider cash-outs underperformed the others in the study’s sample by more than 8%. “Whether insider sales cause the stock to fall or simply reflect insiders’ view that the buyback won’t add value in the long run, the opportunity to cash out stock-based pay gives executives reason to pursue buybacks that do not produce long-term value,” Jackson concludes.
What should regulators do about buybacks, if anything?
Sens. Schumer and Sanders are calling for some unusual measures. They propose setting minimum requirements for corporate investment as a prior condition to buying back stock. Requirements would include such things as paying all workers a minimum wage of $15 per hour, providing seven days of sick leave, and offering decent pensions and reliable health-care benefits.
They also recommend considering limiting the payout of dividends through the tax code.
These proposals have been met with an avalanche of opposition, of course. According to Milano, the chief effect of the senators’ proposals would be to trap more capital inside companies that cannot productively use it.
“Any regulation that limits or restricts buybacks would be extremely bad for the economy and for the markets,” he says. Instead he recommends that companies restructure management incentives, “to re-align their compensation structures to promote good investments.”
Companies that pay bonuses tied to increasing return on capital employed (ROCE) are encouraging the managers of their most profitable businesses to limit their growth investments, Milano says. If your business is already earning 40% ROCE, he questions, why take on a project earning 30% and drag down the average? “Companies can correct this problem by paying bonuses based on an economic profit measure that charges at the cost of capital for the use of capital, but without penalizing new investments that could reduce their average ROCE.”
Other experts like Kurt tend to agree that corporate boards don’t always set the right incentives for executives. But Kurt also sees some value in curbing issuers’ enthusiasm for share repurchases through legislation.
“The senators’ call for limiting buybacks should be carefully considered, as it would motivate executives to find and invest in positive net present value projects, thereby improving corporate earnings in America through higher profitability instead of lower share count,” he says. Kurt also says that imposing a mandatory blackout period for corporate insiders after repurchase announcements may help to some extent, as it would reduce the attractiveness of buybacks by limiting the financial flexibility of executives.
On March 6, 2019, SEC commissioner Jackson requested an open comment period to revisit SEC rules “to make sure they protect American companies, investors, and employees in light of today’s unprecedented volume of buybacks.” He pointed to revisiting the safe-harbor rules for insiders selling upon the announcement of buybacks.
“In a world where stock-based pay gives executives powerful incentives to seek opportunities to sell their shares, SEC rules on buybacks should do more to protect ordinary investors who save for the long run,” according to Jackson. “Outdated SEC rules give safe-harbor treatment to buybacks that do little more than give executives a chance to cash out.”
Ramona Dzinkowski is a journalist and president of RND Research Group.