MARKET WATCH
Corporate America has a love affair with stock buybacks. The latest evidence: Berkshire Hathaway announced a massive $1 billion buyback program as part of its Q3 filings. This year, in total, U.S. nonfinancial corporations could authorize more than $1 trillion in buyback spending. Supporters say that buybacks offer a flexible, tax-efficient means for managers to pass value back to shareholders. Critics complain that buybacks suppress investment, invite overleveraging, and reward managers for short-term, risk-averse performance. On balance, the downsides of buybacks likely outweigh the upsides.
U.S. companies have never been hungrier for their own shares. In Q2 2018, quarterly buyback activity was up 59% YoY for S&P 500 firms. Over the past four quarters, these firms have spent $646 billion on buybacks, an all-time record. When we look at all U.S. nonfinancial corporations, the figures are similarly staggering. So far this year, total buybacks are running at about 3% of GDP; or about double the value of all corporate dividend payments; or about half of all corporate earnings; or about the same as the federal deficit.
The recent rise in buyback activity is the continuation of a longstanding trend. For most of the 20th century, stock buybacks were a rarity. While not explicitly barred by regulators, buybacks were regarded as a form of market manipulation. But amid the Reagan-era free-market zeitgeist, the SEC in 1982 passed Rule 10b-18, which enables companies to safely repurchase their own shares so long as the number of shares repurchased doesn’t exceed a predetermined limit.
The conditions that make stock buybacks economically viable have flourished recently—especially since the Great Recession.
To understand why, let’s think about the two basic choices that every firm needs to make on an ongoing basis. First, what are you going to do with your after-tax cash flow: invest it or redistribute it to stock owners? And second, are you going to augment cash flow by more borrowing or are you going to diminish it by redeeming debt? In recent years, each of these choices has tilted management to favor buybacks. Declining capital productivity and growing market concentration (see: “Declining Business Dynamism: A Visual Guide”) have discouraged investment. Same goes for the rising tendency for companies to stick to their “core competence” instead of expanding to new markets. Additionally, ultra-low interest rates and growing corporate short-termism have encouraged companies to borrow more in order to maximize their current return on equity. Companies are even borrowing explicitly to finance buybacks.
To be sure, some of these macroeconomic drivers have been waning in recent years. Why, then, haven’t we seen buyback activity recede? Two words: tax cuts. Experts say that, in total, the GOP’s tax overhaul will liberate around $3 trillion in profits that have been “stranded” in foreign markets. A Bloomberg analysis estimates that as much as 60% of this cash will go to shareholders (via buybacks and dividends), compared to just 15% that will go to employees (via bonuses and raises).
What’s to like about buybacks? Several things. Buybacks incur a smaller tax liability than dividends, for one. Buybacks also afford more flexibility than dividends, since they can be timed to coincide with quarters in which the company expects a healthy cash flow. Another argument is that buybacks involve two consenting parties. Investors could easily pull their money out of companies that spend heavily on buybacks. Instead, they opt in. Finally, fans see buybacks as a form of trickle-down investment that enables cash to be reallocated to its most productive use.
Critics, however, are not sold on these arguments. Most generally concede that buybacks may be a tax-efficient and flexible way to distribute cash to owners in a low-interest-rate environment. Where they disagree is the assessment that the magnitude of this distribution—much of it leveraged—makes rational sense either for the individual firm or for the economy as a whole.
What the market “wants,” say the critics, is what managers tell the market to look for—and increasingly managers are telling the market to focus on short-term goals, like “making earnings.” This attitude feeds an insatiable appetite for buybacks, which gradually cannibalizes any capacity for long-term growth or innovation. And not only do buybacks encourage managers to disinvest in the future to meet short-term performance goals, they also encourage managers to borrow to finance the buybacks. Such borrowing further imperils the firm’s future by raising both debt service costs and default risk.
CEOs have a good reason to spend heavily on buybacks even if it means racking up debt. Research by Arthur J. Gallagher and Co. reveals that earnings (which rise after a buyback) figure prominently in executive compensation programs at large S&P 500 firms. Such firms are thus induced to announce a buyback when in danger of missing earnings. Consider Humana, which in late 2014 announced a $500 million buyback program that enabled the company to beat its EPS target by 1 cent, triggering higher pay for top managers.
That’s not the only way corporate executives make windfall gains from buybacks. Research conducted by the office of SEC Commissioner Robert Jackson Jr. shows that executives are engaging in an insider trading-like practice by which they authorize a buyback program that inflates share prices and then turn around and sell their own shares at a premium. Senator Elizabeth Warren observed in a recent interview that “stock buybacks create a sugar high for the corporations. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that.” What she could have added is that it’s the insiders who are feasting most off the high and it’s the investor at large who bears most of the post-high crash.
Perhaps most troubling is what buybacks say about our economy—which is that a growing number of businesses don’t see much worth investing in.
It’s revealing that many companies, even after buybacks, are sitting on lots of cash—even aside from the not-yet-repatriated treasure troves abroad. The total value of liquid assets held domestically by U.S. nonfinancial corporations has ballooned to $2.5 trillion as of Q2 2018, nearly double where it stood at the end of 2008. This cash stash has grown even faster than economic output over that time, swelling to 12.1% of GDP (up from 9.6% at the end of 2008).
What comes next? In all likelihood, buybacks will not be on the chopping block until the anti-business populists (on the left or right) get their chance to call the shots. And that won’t happen until the next recession hits, at which point there won’t be many buybacks to complain about. Suddenly, in the midst of a bear market, we will hear CEOs struggle to explain why their own firms are no longer a bargain. Buybacks will no longer be happening—but, sadly, for all the worst reasons.
TAKEAWAYS
- Take note: Buybacks are back in fashion. While stock buybacks have been around for decades, the practice went into high gear following the Great Recession, when the proliferation of ultra-cheap money and dwindling investment opportunities persuaded managers to do (in effect) LBOs on their own firms. This year, flush with cash from the GOP’s recent tax bill, U.S. nonfinancial corporations may push total buybacks to over $1 trillion. As buyback activity has swelled, policy experts have been busy debating their merits. Some see buybacks as a tax-advantaged, flexible way to pass back value to shareholders, while others see them as a manipulative practice used to bolster key financial metrics and reward company insiders.
- Don’t buy the skeptics’ argument on net issuance. Some observers say that the impact of buybacks has been overstated, because the headline figures don’t account for net issuance; after all, companies are issuing new stock at the same time that they’re buying back stock. But as it turns out, adjusting for net issuance doesn’t change the picture. In recent decades, gross issuance has been more than cancelled out by equity retirement due to mergers, exits, and bankruptcies. Almost every quarter since Q1 1997 has been net-negative. In the last few years, net equity issuance has actually been slightly more negative than the buyback totals.
- Don’t try to market-time buybacks. To keep the SEC happy, many companies avoid buybacks during the blackout period weeks before reporting their quarterly earnings. Some media outlets have gone so far as to tie this buyback blackout to the sagging stock market. Does this theory have any merit? It’s true that companies spend less on buybacks during the first month of each quarter. It’s not true, however, that this is having any effect on price. In fact, the S&P 500 actually posts a pretty good return in the first month of each quarter (1.3 percent on average since 2013); it’s the third month that stinks (0.6 percent).
- Expect reforms that target the worst aspects of the buyback economy. Regulatory action is one possibility. In June, SEC Commissioner Robert Jackson Jr. called for an open comment period on the SEC’s buyback rules. Legislative action is another option. Earlier this year, U.S. Senator Tammy Baldwin (D-WI) introduced the Reward Work Act, which would repeal SEC Rule 10b-18. Targeted policies could also be implemented to prevent certain abuses—such as executive bonuses based on “per share” metrics and insiders flipping their shares for profit immediately after a buyback. But ultimately what we need is not so much an economy in which buybacks are illegal but an economy in which buybacks are unwanted.
