by Cydney Posner
According to “Companies’ Stock Buybacks Help Buoy the Market,” by Dan Strumpf, published in the WSJ on September 15, 2014, “[c]ompanies are buying their own shares at the briskest clip since the financial crisis, helping fuel a stock rally amid a broad trading slowdown. Corporations bought back $338.3 billion of stock in the first half of the year, the most for any six-month period since 2007, according to [a] research firm….. Through August, 740 firms have authorized repurchase programs, the most since 2008.” (According to this later piece in the WSJ, there was apparently some tailing off in Q2.)
But are stock buybacks necessarily a good thing? As noted in the WSJ, some “investors applaud repurchases as an appropriate way to return cash to shareholders by buying their stock or putting excess funds to work, akin to dividends but without the tax bite for shareholders. However, in “Share Buybacks Slow as Scrutiny Rises,” published in Institutional Investor on September 19, 2014, S.L. Mintz observes that shareholders are no longer reflexively praising buybacks. The article describes an analyst conference call during which a major corporation announced a substantial share buyback program. Instead of the anticipated silence or benign comments, the announcement was met with a flurry of probing questions about the company’s motivation and expectations, the potential effect on alternative uses of capital, growth and net income, and the analysis behind the target level of leverage. A few days later, S&P downgraded the company’s debt.
As that conference call would suggest, the critics of stock buybacks seem to be having some impact. Critics of stock buybacks are many and, as The Economist observes in “The repurchase revolution,” published on September 13, 2014, they tend to sort themselves into two camps: “Some view buy-backs as a form of financial sorcery, on a par with all those abstruse credit derivatives that helped cause the financial crisis. Others accept that buy-backs are a legitimate way to return cash to shareholders but worry about their extent. They fear they have become a kind of corporate cocaine that induces a temporary feeling of invincibility but masks weakness and vacuity. They worry the boom will damage firms and the economy.”
In “Profits without Prosperity,” published in the September 2014 Harvard Business Review, Prof. William Lazonick plants his feet firmly in both camps, attributing everything from slow economic growth to job instability and income inequality to the scourge of stock buybacks. Depending on your point of view, he may have a point.
His argument is that, instead of using corporate profits for investment in innovation and “productive capabilities,” companies are spending those profits (and more) on enormous stock buybacks. During the last three decades, he maintains, “the amount of stock taken out of the market has exceeded the amount issued in almost every year; from 2004 through 2013 this net withdrawal averaged $316 billion a year. In aggregate,” he argues, “the stock market is not functioning as a source of funds for corporate investment.” Looking at the 449 companies in the S&P 500 index that were publicly traded from 2003 through 2012, he calculates that, during that period, companies spent over 90% of their earnings on either stock buybacks (54% of earnings for a total of $2.4 trillion) or dividends (37% of earnings), leaving “very little for investments in productive capabilities or higher incomes for employees.” As a result, he argues, buybacks are not beneficial in the long run: according to the paper, the “10 largest repurchasers… spent a combined $859 billion on buybacks, an amount equal to 68% of their combined net income, from 2003 through 2012…. Yet since 2003 only three of the 10 largest repurchasers.…have outperformed the S&P 500 Index.” (For some companies, The Economist contends, the result is even worse: buybacks are weakening corporate balance sheets because of quirks in federal tax laws that encourage companies to avoid U.S. tax by hoarding cash overseas, but borrowing in the U.S. to fund the buybacks, potentially resulting in liquidity crises for some companies.)
Of course, as The Economist points out, some commentators take issue with the basic premise that buybacks are really the cause of declines in investment: “Relative to sales, American firms’ investment has indeed been declining. But that could be because of a shift from manufacturing to services, and the rise of the digital and internet economy, which is inherently less capital-hungry. Part of the frustration comes from policymakers, who had hoped ultra-low interest rates might stimulate corporate investment. But [an academic] argues that buy-backs are not to blame: firms are unlikely to alter their long-term investment plans just because long term interest rates have been artificially pushed down. [A financial advisor] says firms are being sensible by restraining investment in the face of economic uncertainty, even as financial investors go wild, fuelled by central banks’ actions.”
Companies contend that stock buybacks are useful because the company’s stock is undervalued, and buybacks demonstrate to the market that they have confidence in their stock. However, in Lazonick’s view, that reason doesn’t hold water: studies show that “over the past two decades major U.S. companies have tended to do buybacks in bull markets and cut back on them, often sharply, in bear markets…. They buy high and, if they sell at all, sell low.” (That position is consistent with the research discussed in this post, showing that “companies do what naïve investors often do: buy when share prices are high, not low. A 2012 study by researchers at the University of Kentucky found ‘strong evidence that stock prices are higher and valuation ratios … are lower during repurchasing quarters relative to non-repurchasing quarters.’”) The Economist also confirms that the proficiency of managers in predicting stock price is “amply illustrated by the fact that buy-backs last peaked in 2007, just before the crash, whereas few firms bought in 2009 when shares were dirt-cheap.” (But see the study of over 2,000 companies between 2004 and 2011, cited in Institutional Investor, which showed that, through market timing, median repurchases were at a price that was 1.8% lower than the average close six months before and after the purchase.)
According to Lazonick, it wasn’t always this way: “[f]rom the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what [he calls] ‘sustainable prosperity.’ This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.” [emphasis added]
What led to this change? In Lazonick’s view, the surge in hostile takeovers in the 1980s proved to be a turning point. These takeovers were justified by corporate raiders on the basis that “the complacent leaders of the targeted companies were failing to maximize returns to shareholders. That criticism prompted boards of directors to try to align the interests of management and shareholders by making stock-based pay a much bigger component of executive compensation. Given incentives to maximize shareholder value and meet Wall Street’s expectations for ever higher quarterly EPS, top executives turned to massive stock repurchases, which helped them ‘manage’ stock prices. The result: Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.”
Along with pressure from Wall Street, the phenomenal rise in stock buybacks over the past two decades can be traced, according to Lazonick, to “the rise of stock-based pay.” From 2003 through 2012, according to Lazonick, the CEOs of the ten largest repurchasers received, on average, a total of $168 million each in compensation, with, on average, 34% of their compensation in the form of stock options and 24% in stock awards. Open-market stock buybacks can “artificially goose” (to use the WSJ’s term of art) a company’s stock price and EPS, even if only temporarily. As a result, they can facilitate achievement of EPS or share price performance targets or allow executives to cash in their options at higher prices. Consequently, he argues, executives are highly motivated to conduct buybacks. The Economist acknowledges that there may be some merit to this suggested causal connection, especially if executives are paid on the basis of EPS targets: “both investors and managers can become addicted to the temporary ‘pop’ that a buy-back can give to a share price….Pay plans can corrupt managers’ motives. By buying existing shares they can offset the effect of new ones created for their personal stock-option plans….Buy-backs can also give a superficial boost to EPS: the number of shares falls more than the decline in profits from higher interest costs.” (Many of us, however, based on non-scientific and purely anecdotal evidence, would shift the emphasis here from compensation to hedge fund “activists” — the “corporate raiders” of this decade — that pressure managements to conduct or accelerate buybacks so that they can take advantage of the resulting short-term increases.)
Instead of using funds productively for investment, Lazonick argues, executives return funds to shareholders in open-market repurchases under the misconception that management’s main obligation is to shareholders and that the company’s primary goal is to maximize shareholder value, as reflected in stock price (MSV): “The MSV school also posits that companies’ so-called free cash flow should be distributed to shareholders because only they make investments without a guaranteed return—and hence bear risk. But the MSV school ignores other participants in the economy who bear risk by investing without a guaranteed return. Taxpayers take on such risk through government agencies that invest in infrastructure and knowledge creation. And workers take it on by investing in the development of their capabilities at the firms that employ them. As risk bearers, taxpayers, whose dollars support business enterprises, and workers, whose efforts generate productivity improvements, have claims on profits that are at least as strong as the shareholders’. The irony of MSV is that public-company shareholders typically never invest in the value-creating capabilities of the company at all. Rather, they invest in outstanding shares in the hope that the stock price will rise.” Instead of paying money to shareholders, Lazonick maintains, companies should use their retained earnings to invest in the “productive capabilities their organizations need to continually innovate. MSV as commonly understood is a theory of value extraction, not value creation.” The Economist takes a step in a different direction, arguing that the idea that buybacks even increase shareholder value is “a delusion. If a firm buys its stock at a price that, with the benefit of hindsight, is low, it transfers wealth from the shareholders who sold too cheaply to its continuing owners. It does not enhance shareholder value overall. Managers’ duty is, of course, to all shareholders.”
Lazonick’s prescription: first, end Rule 10b-18, under which open-market buybacks are conducted (including mandating an SEC study of the possible damage that open-market repurchases have done to capital formation, industrial corporations, and the U.S. economy over the past three decades). Second, because Lazonick attributes the increase in stock buybacks in part to the increased use of stock-based pay for executives, he recommends limiting the use of stock-based pay (which would, of course, trigger a harsh response from those who believe it’s valuable to align management and shareholder interests), subjecting incentive compensation to performance criteria that reflect investment in innovative capabilities and not stock price performance, and preventing executives from selling immediately upon exercise of options. Third, transform boards that are currently dominated by other CEOs by adding taxpayers and workers as directors.
Soapbox: While these recommendations, such as putting employee representatives on boards, may be a bridge too far for U.S. companies at this point (although not for some European companies), it might be worthwhile to consider taking a step in that direction by recognizing that, along with shareholders, the public (who subsidize research and provide other tax breaks for corporations, fund the infrastructure that corporations use and sometimes need to pay for the consequences of corporate wrongdoing) and employees (whose labor contributes to the productivity of the corporation) are also stakeholders whose interests management should take into account.