Share buy-back frenzy needs to wind down
Trend has or soon will reach a point when it becomes plainly dumb to continue doing so
Buy-backs are really popular right now! In February, according to research firm TrimTabs, US corporations announced $153.7 billion (Dh564 billion) in share repurchases — a new one-month record. Investment strategists at JPMorgan Chase & Co estimate that buy-backs will total more than $800 billion this year, which would also be a record. Is that smart or dumb?
As public relations, it seems pretty dumb. The big corporate tax cuts passed by the Republican majorities in Congress and signed by President Donald Trump last year were advertised as a way to boost worker pay. Now Senate Minority Leader Chuck Schumer can say with some justification that “the bulk of the savings from this bill aren’t trickling down into higher wages, but into bigger gains for giant corporations and the wealthy.”
The economics are less clear. In December, the Hoover Institution’s John Cochrane explained the reasoning behind the corporate tax cut like this: “In the end, investment in the whole economy has nothing to do with the financial decisions of individual companies. Investment will increase if the marginal, after-tax, return to investment increases.
“Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by “giving companies cash” which they may use, individually, to buy new forklifts, or to send to investors.
This idealised view, which assumes that cash spent on share buy-backs flows into productive new investments as long as the incentives are right, is not universally held.
Employment instability
Economist William Lazonick of the University of Massachusetts at Lowell has argued for a while now that buy-backs encourage “value extraction over value creation” and have “contributed to employment instability and income inequality”. In the past couple of years, several economists of a more mainstream bent have weighed in with studies linking increased spending on buy-backs to decreased corporate investment.
At this point it’s probably fair to label this work “inconclusive”, as two Federal Reserve economists did in a research note last year. Still, it’s a big deal that there’s now even a debate.
Finally, there’s the question of whether buying back shares now is a smart financial decision by the companies doing it. First, a little history: Until a 1982 ruling by the Securities and Exchange Commission, open-market share repurchases — the kind of buy-back most common today — were of dubious legality.
Companies could make public tender offers to buy shares at a set price, but tender offers to buy your own shares were generally seen as weird and defeatist. This was despite the fact that buy-backs had some clear tax advantages over dividends, the other means of handing corporate cash to shareholders.
Dividends were taxed in the 1960s and 1970s as regular income, with rates as high as 77 per cent, while those who sold shares in a buy-back were subject to much lower capital gains tax rates. Meanwhile, those who chose not to sell paid no taxes until they did.
Still, it wasn’t until Teledyne CEO Henry Singleton used repeated tender-offer buybacks to assemble one of the great stock performance records of all time amid the market carnage of the 1970s that others began catching on. In 1984, after the SEC rule change, hundreds of companies announced buy-backs.
In an influential 1985 Fortune article, Carol Loomis showed that “shareholders in the buy-back companies earned superb returns, far exceeding those accruing to investors as a whole”. Buy-back companies had a median annual return of 22.6 per cent, compared with 14.1 per cent for the Standard & Poor’s 500 Index.
Loomis’ research covered the period 1974 to 1983, when buy-backs were mostly out of fashion and stocks were, too. But even as buy-backs became more common — surpassing dividends in 1997 as the main way US corporations handed cash to investors — academic study after academic study after academic study continued to arrive at similar, if less spectacular, results.
The theory behind the outperformance was that corporate executives know better than outside investors what their company is really worth, so if they buy back shares, it’s a signal the stock is undervalued. In other words, buy-backs are smart.
Most smart ideas in investing eventually become dumb ones, though, and a couple of recent studies paint a more muddled picture of buy-backs. In research done for his doctorate at the University of Southern California Marshall School of Business, Chao Zhuang found that the overall outperformance of buy-backs was driven by a small number of companies that did spectacularly well, and that buy-back decisions appeared to be driven more by availability of cash than by attractive stock prices. In research done for his doctorate at the University of Chicago Booth School of Business dissertation, Matthew Gunn looked at performance after actual repurchases (as opposed to after repurchase announcements, which is what most others have studied) and found that small companies outperformed after buy-backs but big ones did not. Then there’s the simple data point that the all-time high in buy-back activity (to be surpassed this year, perhaps) occurred in the lead-up to the financial crisis of 2008 — not, in retrospect, a great time to be buying stocks.
More prevalent
So as corporate financial moves, buybacks can be smart, and they can be dumb. The more prevalent they are, the more likely they are to be dumb.
Private equity executive William Thorndike junior, whose book The Outsiders chronicled Singleton’s Teledyne and six other companies that used buy-backs to help drive spectacular stock performance (plus one that didn’t, Berkshire Hathaway), put it like this when I talked to him in 2014: “Corporate America’s track record buying in stock is just horrendous.
“It’s terrible. We are now again approaching a peak of buy-back activity, no matter how you measure it. The prior peak occurred in the second-half of 2007, the last market peak. The trough in corporate buy-back activity?
Early ‘09. So, kind of a perfect contraindicator for the stock market.
Still, when he said that, the S&P 500 was at about 2,000. Now, even after a very rough February, it’s at 2,700.
So 2014 wasn’t, in retrospect, an awful time to be buying back shares.
Is 2018? Thanks to the big tax cut they just got, corporations do have a bunch of cash on their hands that they need to do something with. Recent announcements by 51 S&P 500 companies and found that of their $54.5 billion in estimated annual tax savings, 38.7 per cent is going to buy-backs and increased dividends, 22.6 per cent to business investments, 14.9 per cent to employee bonuses, wages and benefits and 2.6 per cent to philanthropy (which leaves 21.2 per cent as yet unaccounted for).
I’m really not sure whether that’s a dumb amount of money to be spending on buy-backs. I am sure, though, that this long buyout boom will eventually cross over the smart/dumb line, if it hasn’t already.