6 Questions About Buybacks, Answered
My July 30, 2019 post on the questionable utility of corporate share repurchase programs struck a bit of a nerve. It kicked off more discussion than my column usually does (what, no love for an Anthropocene discussion?), with comments and strong opinions on both sides, and none in the middle. Who knew corporate capital allocation tactics would be so divisive?
In light of the feedback, I think it’s fair to provide responses to some of the common comments. By frequency of comment, here are my thoughts.
1. Interest rates are low. If you’re a decision maker at a public company, why not borrow money to snap up some of your own shares?
Debt is just another source of capital. The fact that debt is cheap just now does not make borrowing to pay for a repurchase program a better idea than if capital were expensive. Spending debt capital to buy your own shares still comes at the cost of not investing it where it could increase the intrinsic value of the firm. We can say the same for capital from free cash flow and retained earnings for that matter.
Moreover, every dollar on top of a corporation’s debt is a reduction in flexibility into the future. When that company later needs capital because it falls on hard times or has an amazing new opportunity to pursue, the CFO may find additional debt harder to come by. So, say a recession comes, banks are far slower to lend to over leveraged balance sheets and a company has leveraged up to pursue its repurchase plan. The CFO may find she has to decide between selling some of those shares to raise liquidity, and layoffs. She will then quickly realize the time of free cash flow and cheap debt was the time to have strengthened, not weakened, the balance sheet. These risks are real: Using low interest rates to buy back shares is one reason corporate debt is today at historically high levels.
Finally, buying back shares keeps money away from tangible investments and therefore still sitting in the financial sector, not in the real economy: Nobody was paid more, no contractors retained, no R&D funded, no production capacity was increased, no new jobs were created. Meanwhile, the corporate balance sheet was weakened by more debt. Rather than sustaining the real economy, the low-interest loan-funded buyback mainly moves the liability from equity to bonds. This in turn can cause a feedback loop as people who get the payment from the bonds still want to invest in something, so money, now multiplied not by growth but by financial engineering, raises the risk of stock bubble inflation as the same capital can chase the same shares multiple times simultaneously.
2. Buybacks are a better way to return money to shareholders than dividends because, of the two, only dividends are taxed.
There’s a good reason shareholders aren’t taxed when the company buys back its shares: They didn’t get anything. Dividends are cash, buybacks are cap table reorgs that may or may not give a short term sugar high to the share price. The only way to realize a benefit from a share buyback is to sell your shares during the sugar high period (then you will be taxed).
3. Executives who are incentivized by share price performance really don’t have much choice but to repurchase some of their firm’s own shares.
True, management incentives often align with maximizing the current perception of value, rather than actual long-term value, which means they are often working at cross-purposes to the regular shareholders. Executives should not be given incentives to deploy capital and labor resources to ends other than long-term value creation. More on this below at No. 5.
4. The idea that buybacks don’t increase a corporation’s book value or intrinsic value has been debunked.
I’m not yet aware of a persuasive debunking. If you’re going to buy and hold a company for the long term with the expectation of growth and returns at least equal to maintaining your money’s purchasing power, that company, at a minimum, needs to be productive and it needs to have cash flow. Except for on the intrinsically meaningless per-share basis, buybacks achieve neither. So it’s hard to see where enterprise intrinsic value is helped (with the exception of the scenario in No. 6, below) by a repurchase program. Again, non-producing, non-cash flow generating companies make for terrible investments, and buybacks contribute to neither attribute. In fact, they prevent investment into more production and cash flow.
5. Buybacks are the lowest risk way for management to beat EPS expectations.
This is true, you got me. But for ordinary, long-term shareholders (like retirement plan participants) that doesn’t mean much, because shrinking the denominator (number of shares) doesn’t make the pie (value of firm) any bigger. If you’re looking for organic growth, it’s better to look at revenue and margin trends than at earnings. Earnings are too easy to manipulate via buybacks and other shenanigans. Price-to-book and price-to-revenue are therefore better indicators of value than price-to-earnings. Where you see a company that looks expensive on a price-to-revenue basis but looks reasonably priced on a price-to-earnings basis, there’s a good chance you’re looking at a larger buyback scenario, where the low P/E wasn’t caused by growing the numerator of earnings, but merely by shrinking the denominator of shares outstanding. And if you’re spending your cash flow or taking on debt for the buyback program, you’re reducing future flexibility and increasing the risk to your business (see No. 1 above). In this way, buybacks represent zero alignment between management and shareholders (see No. 3 above).
So this one is on boards of directors. If you are a manager incentivized to hit EPS targets, a buyback program is indeed a lower risk and quicker way to earn those incentives than investing in your best new growth idea, because while you think that your idea will work out, there’s always the chance it won’t. If an executive is paid to engineer a fake EPS beat, they will move mountains to do that. So to drive real economic value, board compensation committees should be thinking about better aligning management incentives with longer-term growth and underlying value creation.
All of which fairly begs the question:
6. Is there a case where buybacks make sense?
Yes, of course. There can be and are times when a corporation repurchasing shares is likely to be among the best long-term investments the company can make. For example, if a management team is certain that their shares are priced far below what they believe is the firm’s intrinsic value, they can grow the value of the firm via filling up the balance sheet with underpriced T-shares, and then waiting for those shares to reach/return to a fair valuation. In this scenario, the buyback is no different from any other investment the firm may make, except at their own company, managers are legally in possession of insider information with a clearer view to proper valuation. They can and should use that advantage when it works in the fiduciary practice of investing where they think they can get the highest return. (Insider buying is a closely watched indicator on this same basis.)
In addition, holding T-shares is a good way to fund an employee incentive program (ideally for all the employees, not just the C-suite), because distributing T-shares as comp is better for all the shareholders than is issuing new shares, which of course is dilutive.
So to be clear, I’m not in the “ban all buybacks” camp. In situations like the example above, a repurchase can be a useful tool of corporate finance. I am in the camp that thinks companies and the economy at large would benefit from structural guardrails to prevent management teams from using cap-table shell games to give the appearance of more value than there is. One quick fix would be to make sure no one is paid to shrink the number of shares just to make the earnings-per-share look bigger. A simple rule eliminating all incentives based on per-share measured numbers might suffice.