Our politicians keep edging closer to your portfolio …
Last week it was Trump, looking for ways to limit investor exposure to China.
Yesterday, we learned that Bernie Sanders has vowed that, if elected president, he would ban large-scale stock buybacks.
This comes after last February’s New York Times op-ed piece which he penned with Chuck Schumer, reading:
At a time of huge income and wealth inequality, Americans should be outraged that these profitable corporations are laying off workers while spending billions of dollars to boost their stock’s value to further enrich the wealthy few. If corporations continue to purchase their own stock at this rate, income disparities will continue to grow, productivity will suffer, the long-term strength of companies will diminish — and the American worker will fall further behind.
In recent history, no other investment concept has become as vilified as stock buybacks. Are they really an evil tool that enriches only wealthy executives at the expense of long-term corporate growth and employees?
In short, while a lengthy answer is more nuanced than a binary “yes” or “no,” we live in a sound-bite world, so here it is: buybacks are hardly the tool of economic repression these politicians are painting them to be. But everyone loves a scapegoat, and in this case, buybacks are the easy target.
It’s likely you’ll be hearing more about buybacks as we approach the presidential election. So, in today’s Digest, let’s scratch the surface on this complex topic so you’ll be better up to speed in the coming months.
***What, exactly, is a stock buyback?
In short, it’s when a company uses its available cash to repurchase shares of its own stock.
Take Apple. Just as you or I could go buy shares of the tech giant in our brokerage account, so too could Apple buy its own shares from some investors in the market looking to sell.
But here’s the difference — since Apple can’t be an investor in itself, when it buys its own shares, these shares are effectively “retired” or cancelled. In other words, they’re no longer available to the public. This reduces the number of total shares that exist in the market — something called the “float.”
In our example, that would mean that when Apple buys back its stock from, say, you and me, it re-absorbs that portion of its ownership that you and I had previously held. This means the total number of Apple shares that exist in the world is now less by whatever amount you and I had owned.
As a result, assuming Apple makes the same total amount of profit, then each remaining share is now entitled to just the tiniest bit more of that profit since there are fewer shares out there in existence.
***Why would a company want to buy back its stock at all?
Let’s start broad.
When you strip everything else away, a CEO’s job boils down to one simple question:
How should I use the cash available to my company in a way that maximizes value?
The reality is there are only five options: 1) invest in a new product or service in hopes it will generate future profits, 2) buy another company in hopes it will boost future profits, 3) pay off corporate debt, 4) pay dividends, and 5) our topic du jour — use that cash to buy back shares of its own stock.
How a CEO uses available cash becomes his/her “capital allocation” plan. And the goal of this plan is simple — create as much economic value for investors and stakeholders as possible.
Now, it’s important to note that none of these five uses of cash are “good” or “bad” by themselves. They are merely tools.
As a comparison, think about a car. Is a car a good or bad tool? Well, when used properly in the hands of a responsible adult, it’s an amazing tool providing mobility, comfort, and convenience. But when used in the hands of an inexperienced teenager driving recklessly, it’s a dangerous weapon.
It’s the same thing with how a CEO might allocate his/her cash …
Using cash to buy a small technology company at a bargain price that will drive increased profits for years to come? Great use of cash!
Using cash to buy an overpriced, bloated, debt-ridden carcass of a company that’s selling a product that technology will render obsolete in two years? Awful use of cash!
So, why would a CEO ever choose buybacks? What’s the benefit?
Well, when executed wisely, buybacks are a huge value creator — and that’s when CEOs purchase shares at market prices they believe are lower than what those shares are really worth. In essence, they pay $5 per share for a stock they believe is actually worth $7. When this happens, that $2 incremental spread is a value creation for the company and its investors — it increases the value of the remaining shares existing.
Warren Buffett is a huge fan of buybacks, saying “When stock can be bought below a business’s value it is probably the best use of cash.”
***So, why are some politicians up-in-arms about buybacks?
Well, one argument is that CEOs overpay for their buybacks.
Hypothetically, this would destroy value, since CEOs would basically be exchanging, say, $5 of cash for a share of stock that’s only worth $3.
So, is it true CEOs routinely pay too much?
In 2015, O’Shaughnessy Asset Management published a research piece on the topic, making the distinction between “low conviction buybacks” and “high conviction” buybacks. High conviction refers to large-block purchases that really move the needle.
From that report:
A common criticism levied against buybacks is that corporate managers mistime their repurchases, buying back stock at expensive prices. But this hasn’t been true for the high conviction buyback firms.
Since 1987, roughly half of all high conviction buybacks conducted by large U.S. firms were conducted when the firm’s stock was in the cheapest quintile of all large stocks; fewer than ten percent of high conviction buyback firms bought back shares when they were in the most expensive quintile of the market.
Might a select few CEOs pay too much? Absolutely – especially in the last few years of this lengthy bull market as valuations have risen. But that in no way makes it fair to generalize and claim that the majority of stock repurchases are executed at lofty prices.
***A second complaint is that buybacks are nothing more than a tool to inflate earnings-per-share figures so fat-cat executives can hit their bonuses and get richer
The data doesn’t support this gripe.
Goldman Sachs studied this and found that executives whose compensation depends on EPS did not allocate a greater proportion of their total cash spending to buybacks in 2018 when compared with companies where management-pay was not linked to EPS.
In fact, the 247 companies in the S&P 500 with incentive compensation programs that are linked to earnings-per-share actually allocated a smaller share (28%) of cash to stock buybacks than the 253 companies without a performance metric linked to earnings-per-share (31%).
Yet, in an effort to be objective, might some CEOs attempt to use buybacks as an EPS-inflating tool? Sure! Most notably when timed just before an earnings report. But when that happens, it’s usually transparent, and called out for what it is — artificial earnings growth rather than organic growth.
***Another political gripe is that buybacks — which are at record levels — are coming at the expense of growth initiatives
The politicians that make this argument are forgetting something rather important …
Companies are generating more profits and cash than they have in years past, so the increased buybacks are not coming at the expense of R&D and growth investment. Back to the Goldman Sachs report:
Growth investment (capex, R&D, and cash M&A) has accounted for a larger share of cash spending than shareholder return (buybacks and dividends) every year since at least 1990.
So, yes, we’re at record highs for the amount spent on buybacks. But that’s taken out of context and it focuses on absolute dollar amounts. When evaluated contextually, these buybacks haven’t encroached on the amount of capital allocated to growth at all.
Plus, politicians who make this argument are basing it on a huge assumption — namely, that cash allocated to new growth initiatives will always be fruitful and create value. It’s a bit like saying “well, if that cash had gone toward research instead of buybacks, it would have invented the next iPhone.”
Is that fair?
The truth is it’s impossible to know what an investment in a new product will yield. After all, for every “iPhone” example, we must counter with the very real risk that a company will invest hundreds of millions (or more) into a debacle such as “New Coke.”
The idea that reinvestment is always a better call than buybacks is an impossible conclusion — and if you want to debate that, okay, but first, let’s grab a Crystal Pepsi, then puff down a RJ Reynolds smokeless cigarette, then squeeze in a fast game on our Nintendo Virtual Boy, then perhaps listen to a song on our Microsoft Zune, then we’ll debate.
The reality is that CEOs make the best capital allocation decisions with the limited knowledge they have. Sometimes that calls for buybacks, other times it calls for growth investment, (and sometimes it calls for any of the other uses of cash). But it would be woefully naïve to suggest one particular use — like growth investment — is always the right call.
Now, you might argue that a CEO has no business spending cash to buy back shares while simultaneously laying off workers (which certainly happens). But that’s a bigger, existential business question — basically, who is a CEO most responsible to? Shareholders or employees?
That’s a Digest for another time…
***To prevent this issue from growing too long, let’s wind this down
Buybacks are a complex topic with many additional layers we didn’t have time to delve into today. That said, as we approach the 2020 election and you hear some politicians demonizing them, remember that, fundamentally, a buyback is nothing more than a tool.
Is this tool used foolishly and inappropriately by some CEOs? Absolutely.
But banning buybacks entirely because of this makes about as much sense as banning all cars because some teenagers have wrecked them.
Have a good evening,
Jeff Remsburg
