How Stock Buybacks Undermine Healthy Capitalism
Lots of Wall Street analysts and investors like it when companies buy back their own stock. Such stock buybacks typically mean that the company is on solid financial footing and wants to reclaim more control over its own destiny, and for investors, these buybacks often mean a significant profit on their investments. (As a recent article on TheStreet.com happily put it, “What are stock buybacks? Here’s how they make you money.”) Yes, stock buybacks can make both shareholders and share sellers feel fat and happy. But from the perspective of a healthy capitalism, they couldn’t be more wrong.
Stock buybacks, sometimes called company share repurchases, aren’t productive. They may create wealth, but this isn’t organic wealth creation—it’s a function of artificially limiting the supply of a stock. Stock buybacks don’t mean the underlying company is worth more; the buyback hasn’t helped it to sell more of its products or services.
In fact, the contrary is more often true. Using profits and other company resources (often the issuance of debt) to buy shares limits a firm’s ability to innovate, to invest in R&D, to scale production, to better compensate desirable employees or to do anything else that may augment a company’s worth. Buybacks create the illusion of value by artificially creating a relative scarcity of shares. But there is a fatal flaw in the logic of share repurchases: For the supply and demand dynamic to raise prices, it takes more than restricting supply—there must also be demand. If a company squanders its resources on buybacks to the point that it’s less competitive with its peers, it doesn’t matter how few shares are available because investors won’t want to own the stock.
So buybacks, apart from near-term benefits to executives who are compensated in company shares and options, are not great builders of value. Buybacks don’t add to the size of a company’s economic pie; they simply deliver a bigger slice of the existing pie to the largest shareholders, who are usually executives of the firm. Since the largest individual shareholders of any stock are typically executives of the firm, you can understand why companies promote buybacks that raise the value of their stock. But why aren’t more investors avoiding companies overspending on buybacks?
Because they either don’t know, or they don’t care. Most stocks today are purchased without any regard for what a company does, what it makes, or how it manages its finances. Today, the main reason to buy a stock is because it is in an index; many retail investors, and probably some institutional ones, don’t even know all the companies that constitute that index when they buy an index fund or an ETF. If they do, they’re unlikely to steer clear of the index simply because one company, constituting a small fraction of that index, engages in an unwise but not immediately catastrophic practice. Companies know that, and they know that as long as index funds have to own them, there is demand for their shares, regardless of growth or fundamental value in the underlying business.
In this world, where the demand part of the supply/demand curve is guaranteed, limiting the supply of shares would seem to make sense. Except spending on your own shares instead of on R&D, growth or employee development means you’re not innovating. And, today more than ever, innovation is the clear path to growth, profits and even domination.
Are stock buybacks truly the opposite of creating fundamental value? Yes, so much so that before 1982 companies buying back their own shares could be charged by the SEC with market manipulation. The pervasiveness of buybacks today is not only unwise, but also dangerous. It’s part of how systems collapse: If stock buybacks become so pervasive that, people can see the lack of underlying value in companies, they’ll lose faith in the ability of markets to reflect underlying worth. And that contributes to the sense of investor insecurity that leads to market volatility, if not collapse.
In some cases, stock buybacks might actually lead to company collapse—and the loss of lives. In a recent New Yorker article, the economist William Lazonick pointed out that between 2013 and 2019, Boeing spent $43 billion on share repurchases—104 percent of its profits during that period. At the same time, Boeing engineers are now disclosing, they were under relentless pressure to cut costs on the development of the now-infamous Boeing 737 Max, even when they protested that doing so would create safety risks. They were right; Boeing management was wrong. And possibly as a result, hundreds of lives have been lost, and Boeing’s reputation and business prospects have been deeply damaged for years, if not decades.
When you encounter a company that believes it really has nothing better to do with its money than move it around the different cells of a share ownership spreadsheet, I would suggest what you see there may not represent fundamental long-term value. Even in the age of passive investing, demand for such companies won’t last forever. One day, investors will once again care what a company actually does.