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7 Reasons Stock Buybacks Should Be Illegal


stock buybacks - 7 Reasons Stock Buybacks Should Be Illegal

Editor’s note: This story was previously published in February 2019 It has since been updated and republished.

Did you know that stock buybacks were illegal until 1982? It’s true.

stock buybacks

Source: Shutterstock

The SEC, operating under the Reagan Republicans, passed rule 10b-18, which made stock buybacks legal. Up until the passing of this rule, the Securities Exchange Act of 1934 considered large-scale share repurchases a form of stock manipulation.

The 1982 rule provided “safe harbor” protection as long as a company bought back no more than 25% of its average daily volume over the previous four weeks and didn’t buy its stock at the beginning or end of the day’s trading. The SEC Commissioners argued at the time that the rule would encourage higher stock prices thereby benefiting investors across the board.

Care to guess who the SEC Chairman was in 1982? John Shad. 

John Shad was a former executive with E.F. Hutton. It seems odd that someone who worked for a company that directly benefited from the rule change (higher prices equals higher commissions) would be in charge of the agency created to protect investors. In hindsight, it seems like a massive conflict of interest, but I digress.

The reality is that stock buybacks have helped the wealthiest 1% get even richer over the past 36 years.

In 1982, according to the Economic Policy Institute, the average CEO earned 50 times the average production worker. Today, the CEO Pay Ratio’s increased to 144 times the average worker with most of the gains a result of stock options and awards.

Suggesting stock buybacks ought to be illegal isn’t a crazy notion. Here are seven reasons why:

Stock Buybacks Reward a Lack of Creativity and Innovation

By mid-December of 2018 following the corporate tax cut that was supposed to help the middle class, America’s public companies had announced $1.1 trillion in stock buybacks with $800 billion already repurchased with only two weeks left in 2018. A record year by any standard.  

Apple stock aapl stock

Source: Shutterstock

On the one hand, buybacks of this size make sense in a year that saw many stocks lose ground. On the other, 2018 was the first year of negative returns for the S&P 500 since 2008, making the latest bull market one of the longest in history.  

In the eyes of many, stocks are overvalued, despite their retreat in 2018.

Companies like Apple (NASDAQ:AAPL) ought to have better things to do with their cash than buying back billions of dollars in stock. It stifles creativity and innovation, something Apple’s going to need if it wants to keep growing.

“I find it absolutely mind-numbing that a company like Apple can sit on $260 billion of cash,” Morgan Creek Capital CEO Mark Yusko told CNN recently. “You’re telling me that all these genius people can’t think of one intelligent thing to do with that capital?”

I’m a fan of Tim Cook and Apple, but stock buybacks are not the answer to the company’s slowing innovation.

Stock Buybacks Hurt the U.S. Economy

This argument is a rather circuitous one so bear with me.

tax tips, tax breaks, tax questionsCNN recently reported that America’s total debt is nearly $22 trillion, an average of $67,000 per person. That’s right; split between all U.S. citizens, you’d owe $67,000 for your share of America’s debt.

In 2019, America’s bill for the interest on that debt is $383 billion; by 2025 it’s projected to hit $928 billion or about the same amount as corporate stock buybacks in 2018. Imagine if the dollars directed to share repurchases were redirected to paying down the national debt. At the current pace of stock buybacks, the debt problem could be eliminated in 22 years.

But of course, that wouldn’t help the wealthiest 1%.

Consider this: Many economists argued that the Trump tax cuts would worsen the debt situation and they were right. The Congressional Budget Office predicted that the Trump tax cuts would add $1.9 trillion in principal and interest to the deficit by 2027. Since Trump’s become President, the national debt’s increased by more than $2 trillion.

Thus, the president and Congress face a difficult decision.

Increase taxes, cut spending or do a combination of both. Do nothing, and the deficit continues to increase, and the U.S. dollar risks becoming irrelevant on a global scale as its creditworthiness crumbles.

Trump’s plan was simple: Cut corporate taxes and the savings will be reinvested. The $1.1 trillion in stock buybacks in 2018 suggests that didn’t happen. God help the common man if we go into recession in the next two years because there will be nothing available to reignite the economy. The cupboards will be bare.

Stock Buybacks Add to Debtload

The previous reason why stock buybacks ought to be illegal had to do with the federal government’s mishandling of an economy on the rise. I never thought the corporate tax cuts were a good idea.

“America’s crumbling infrastructure isn’t going to be fixed when the federal government’s revenues are going the wrong way. President Donald Trump promised an infrastructure plan, but with lower revenues expected over the next decade, it will be tough for him to deliver,” I wrote in December 2017. “And don’t for a minute expect private businesses to jump into the fight to save the day with their new-found wealth.”

They haven’t. And won’t.

So, here we have a federal government drowning in debt, encouraging public companies to do the same through stock buybacks. Unfortunately, as bond guru Jeffrey Gundlach suggests, increasing stock buybacks reduces the solidity of a company’s balance sheet.

“So, the balance sheets of corporations are balanced on ever-dwindling equities as they buy back shares and increase their leverage ratios. And that’s not good,” Gundlach stated in January. “Strong balance sheets are going to be the way to survive during the zigzag of 2019.”

In Gundlach’s estimation, strong balance sheets are far more critical than strong earnings.

With 62% of investment grade debt maturing over the next five years, there are a lot of companies that are going to wish they didn’t buy back so much stock.

Stock Buybacks Reduce Capital Spending

All businesses have one cash flow bucket. Cash goes in; cash goes out, the difference is the capital it can allocate for uses other than keeping the company running. These uses include debt repayment, dividends, stock buybacks, acquisitions, and investing in the future.

Source: Shutterstock

The Trump corporate tax cut was intended to put more money in corporate coffers so they could invest in the future creating more jobs. While the unemployment rate is healthier than it’s ever been, it’s unlikely that it was the result of increased capital spending.

In the last two years of the Obama administration, five million jobs were created while 4.8 million were created in the first two years of Trump’s presidency, suggesting that almost any economic strategy would have worked for the incoming president.

According to Just Capital, 56% of the tax savings from the new corporate tax rate went to shareholders with just 24% allocated to wages and job creation. Just 8% went to improving products and innovating, and the remainder went to lower prices and community involvement. In 2018, the bucket spilled over for stock buybacks. Capital spending, not so much.

Stock Buybacks Provide a False Picture

The main argument for stock buybacks is that the reduction in shares outstanding increases earnings per share which is the primary driver of higher share prices. A secondary consideration is that every shareholder gets a more significant piece of a smaller pie.

magnifying small capsIt’s no wonder, then, that Warren Buffett’s a big fan of stock buybacks. Every time a company held by Buffett announces a $10 billion share repurchase program, he rubs his hands with glee because his ownership stake goes up without making an additional investment. It’s the power of compounding in reverse.

In 2014, I wrote an article entitled The 2 Biggest Lies of Buybacks. One paragraph sticks out for me to this day.

“The premise that buybacks boost earnings is a big fat lie. It’s an optical illusion meant to distract investors from the truth: Bottom-line growth is measured by net income only and not earnings per share,” I wrote in 2014. “After all, you wouldn’t judge top-line growth by anything other than revenue, would you?”

In the article, I used Exxon Mobil (NYSE:XOM) as an example of how buybacks hide the truth. Because it bought back 4.4 billion shares between 2009 and 2013, while its net earnings were down 28% that year, EPS were down a more palatable 15%.

You can argue till the cows come home why I’m wrong, but a 28% decline is a 28% decline, no matter how many shares are outstanding.

Stock Buybacks Create Income Inequality

As I pointed out in a previous slide, the period between 1982-2017 has created a much wider gap between the person at the top of the pyramid, the CEO, and the workers on the bottom.

According to the Harvard Law School Forum on Corporate Governance and Financial Regulation, CEO pay between 1990 and 2016 increased by 438%. Meanwhile, according to the Pew Research Center, the average seasonally adjusted hourly wage in the U.S. between 1964 and 2018 grew by just 12% in constant 2018 dollars.

The legalization of stock buybacks in 1982 gave CEOs a massive incentive for repurchasing their company’s shares. Their pay packages went through the roof while the rank-and-file employees saw their wages barely budge.

A rational person would see the causal link when it comes to income inequality.

CEOs Love Stock Buybacks

Hey, if you’re a CEO, I wouldn’t blame you for taking advantage of the system. It’s not your fault that the board of directors gave you such a lucrative compensation package. After all, they didn’t have to. It’s not as if you were holding a gun to their heads.

Who wouldn’t like a pay package that grows and grows and grows without any additional effort?

As a writer, I’d love to be able to get paid X dollars to write this article today, X dollars plus next year, and X dollars plus, plus, the year after that. It is not going to happen. But it happens every day for CEOs. Is it any wonder why they love stock buybacks?

Let’s take Qualcomm (NASDAQ:QCOM) for example.

In fiscal 2018, it repurchased 279 million shares of its stock for $22.6 billion. That alone would have a material effect on earnings per share, which is a significant factor in Qualcomm’s annual cash incentive plan, as well as a considerable influence on both its performance stock unit and restricted stock unit awards.

In fiscal 2018, CEO Steve Mollenkopf received total compensation of $20.0 million. The year before that it was $11.6 million and $11.1 million in fiscal 2016. Of Mollenkopf’s total compensation, 86% was EPS-related to one extent or another.

Do you think he’s got an incentive to repurchase Qualcomm shares? I sure do.   

As of this writing Will Ashworth did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2019/06/7-reasons-stock-buybacks-should-be-illegal/.

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