Share Buybacks: Mismeasured and Misunderstood

In March of this year, Forbes published an article with the following lede:

The Economist has called them “an addiction to corporate cocaine.” Reuters has called them “self-cannibalization.” The Financial Times has called them “an overwhelming conflict of interest.” In an article that won the HBR McKinsey Award for the best article of the year, Harvard Business Review has called them “stock price manipulation.” These influential journals make a powerful case that wholesale stock buybacks are a bad idea—bad economically, bad financially, bad socially, bad legally and bad morally.

There is no shortage of hand-wringing over “excessive” stock buybacks, either in the academic literature or in the popular media. Such criticisms are misguided in two crucial ways. Methodologically, they overstate the scale of the problem (such as it is) by observing gross payouts instead of payouts net of issuance, and by neglecting the extent to which firms are simply substituting low-interest debt for equity financing. Second, while accusing shareholders of myopia and executives of cupidity, such critics are not taking a properly panoptic view of the function that buybacks serve in the broader equity ecosystem.    

I.

A 2018 report by the Roosevelt Institute cites a statistic that lies at the heart of alarmism over the size and scale of stock buybacks:

Over the last decade-and-a-half, firms have sent 94 percent of corporate profits out to shareholders, in the form of buybacks, as well as dividends, leaving companies to argue that there is little available for employee compensation or investment.[1]

But other recent research dramatically qualifies such despair. Harvard researchers Jesse Fried and Charles Wang offer a persuasive rejoinder to concerns over the scale of equity outlays:

During 2007-2016, S&P 500 firms distributed to shareholders more than $4.2 trillion through stock buybacks and about $2.8 trillion through dividends. These cash outflows, totaling $7 trillion, represented 96% of these firms’ net income during that decade. But during this same period, S&P 500 firms absorbed, directly or indirectly, $3.3 trillion of equity capital from shareholders through share issuances. Net shareholder payouts from S&P 500 firms were therefore only about $3.7 trillion, or 50% of these firms’ net income.[2]

Moreover, this figure pertains only to those firms listed on the S&P 500, which are relatively mature, vs. publicly traded firms not listed on the index. When accounting for unlisted public firms, who are net importers of capital, the share of corporate income channeled into buybacks and dividends falls further, to 41%.[3] Yet net equity outlays don’t necessarily translate into a reduced cash position. Low-interest rates mean that firms can afford to reorient their balance sheets away from equity and toward debt financing. In fact, in the years 1989-2012, fully 42% of equity payouts were offset by a debt issuance that same year.[4] In a recent working paper, Mark Roe takes direct aim at this argument:

Low interest rates pushed corporate America to substitute low-interest debt for stock. Viewed as a capital structure decision, the double trend—more low-interest debt, less equity—fits the short-termist critique poorly. Overall, public firms have more cash, not less.[5]

Not only do public corporations retain more of their earnings than is indicated by gross equity outlays (including debt financing, total corporate cash balances rose from $3.3 to $4.5 trillion between 2007-2016[6]), there is evidence to suggest that this extra liquidity is flowing into long-term investments such as R&D. Again quoting from Fried and Wang:

Further, we show that public firms deployed much of this capacity for investment in R&D and CAPEX. In absolute terms, total investment (R&D and CAPEX) rose to a record level. And relative to revenues, total investment rose to levels not seen since the late 1990s economic boom.

If anything, these large gross capital movements, and net equity outlays, are a sign of economic efficiency, not destructive short-termism. As John Cochrane explains in the Wall St. Journal, if Company A is short on investment ideas but long on cash, and Company B is facing the opposite situation, a share buyback allows investors to reallocate their capital to its higher-value use (in the hands of Company B).[7] Nonetheless, critics maintain not only that the scale of buybacks is immense, but that their influence is malign.

II.

i.

Share buybacks, to the extent that they are in fact occurring, are highlighted as one of many symptoms of a greater pathology plaguing our economy: short-termism.

Contra the proponents of the efficient markets hypothesis, who argue that prices on the stock market incorporate all extant information about a firm’s current and expected future profits - discounted accordingly - there exists a considerable economics literature that grants the premise that shareholders are rational, but that posits that this individual shareholder rationality does not aggregate to rationality at the market level. One such market failure is said to obtain in publicly traded equities, known variously as “short-termism, “quarterly capitalism”, or, more formally, the “myopia hypothesis.”

While accusations of stock-market short-termism are intellectually buttressed by different arguments[8], the most common strain of the “myopia hypothesis” proceeds as follows: the managers of publicly traded firms, whose shares trade in deep and liquid markets, are hostage to the over-diversified and under-informed marginal shareholder, who moves the share price not in response to new information about a firm’s fundamentals, but in response to the latest, easily digestible quarterly earnings report. Instead of undertaking investments in the present that might have a substantial return several years down the road, managers are induced to mimic the priorities of transient shareholders uninterested in a firm’s long-term strategy. Future-oriented firms that resist this temptation will be penalized, finding it more difficult to raise capital. This will in turn affect their bottom line, jeopardizing their ability to even survive to the point at which they would reap the returns from their long-term investments.

The seeming insuperability of such incentives has led to calls for a variety of legal remedies: from relatively minor vesting restrictions on executive stock options to a wholesale paradigm shift from our free-wheeling “liberal market economy” to a Franco-Germanic-Japanese style “coordinated market economy” in which patient, farsighted institutional bloc-holders substitute for a dispersed set of myopic, over-diversified shareholders.[9]  While few policymakers have the stomach to commit hari-kari on our institutional innards in such a wholesale fashion, more “modest” proposals are advanced (and often achieved) by figures such as Barack Obama and Elizabeth Warren on a routine basis, but without the redeeming Swiftian irony or humor.[10] One such cure proposed for the short-termism disease is a restriction on share buybacks. I will spend the remainder of this post summarizing why critics find buybacks to be problematic, countering this diagnosis with arguments as to the important role that buybacks play in equity markets, and will suggest that this proposed “cure” is likely to be iatrogenic.

ii.

If corporations are disincentivized from reinvesting their profits into the firm, as the short-termists claim, what are they to do with their earnings? Disburse them to shareholders, either in the form of dividends or share buybacks. Shareholders force corporations to eat their seed corn without a thought for next year’s harvest. The lower a firm’s free cash flow, the less ability it retains to take on new investments, even those with a high net-present-value. But no matter: the corporate form is not to be treated as the vehicle for the transformation of debt and equity into a value-added product, but as a piñata full of cash.

Forbes’ Steve Denning articulates buybacks’ contribution to short-termism thusly:

 

 [Corporate executives] hit upon a magic shortcut: why bother to create new value for shareholders? Why not simply extract value that the organization had already accumulated and transfer it directly to shareholders (including themselves) by way of buying back their own shares? By reducing the number of shares, firms could, as a result of simple mathematics, boost their earnings per share. The result was usually a bump in the stock price—and short-term shareholder value.

Moreover, in many progressive circles, share buybacks are a hair’s breadth from outright fraud. Legally ambiguous prior to a 1982 rule change by the SEC which provided clear “safe harbor” provisions for the practice, buybacks have since become a key tool in corporate finance.[11]

Rather than serving a sensible capital rebalancing purpose, such critics claim that buybacks are used to game the next earnings report to appease shareholders and juice executive compensation metrics. By reducing a corporation’s cash (an asset), buybacks increase Return on Assets (ROA) as well as Earnings per Share (EPS) by reducing the number of shares outstanding.

For many academics and policymakers, stock buybacks are not merely presumptively illegitimate, but are illegitimate per se. William Lazonick, in the aforementioned (award-winning) Harvard Business Review article “Profits without Prosperity”, states bluntly that “the reasons commonly given to justify open-market repurchases all defy facts and logic” (emphasis mine). He goes on to claim that “the only plausible reason for this mode of resource allocation” is the greed of corporate executives. He is similarly forthright in his prescription:

The American public should demand that the federal government agency that is supposed to regulate the stock market rescind the “safe harbor” that enables corporate executives to manipulate stock prices…the SEC may well be advised to make open-market repurchases illegal.[12]

But is it possible that share buybacks serve a legitimate financial function? If so, any restrictions on corporations’ ability to restructure their liabilities in this way will have unintended consequences that may completely offset any salutary effects such a restriction might have.

Because share prices often rise in anticipation of an announced buyback program, critics claim that corporate executives repurchase shares to goose the company’s short-term valuation, to which their own stock options are tied. But this same empirical pattern is also consistent with a properly incentivized management returning cash to shareholders when the company lacks investment opportunities with sufficiently high net present values.

As Hoover fellow John Cochrane explains, not every firm in the economy faces the same spectrum of profitable investment opportunities at the same time. It is therefore efficient for cash to flow from those firms that have the lowest marginal returns on investment to those that have the highest. Skeptics of this argument maintain that these “mature” firms with a reduced need for cash will, by virtue of their longevity, have developed “dynamic capabilities” that would allow them to exploit a functionally inexhaustible set of investments whose returns exceed the hurdle rate.[13] But even ignoring organizational diseconomies of scale and granting this heroic assumption, we cannot wish away one of the core features endemic to the relationship between a corporation’s shareholders and its managers: agency costs.

Because a corporation’s management does not fully internalize the impact of its actions on the firm’s share price, there exists an incentive misalignment vis-à-vis shareholders.[14] Managers are perennially tempted to allocate the firm’s resources towards assets that do not benefit shareholders, but instead improve managerial consumption (in Cochrane’s example, a fleet of corporate Ferraris.) Such waste need not be so conspicuous, however. Subtler forms, such as “empire building”, consist of mergers and acquisitions which are not value-maximizing, but which serve to aggrandize the power of the CEO. Thus, even assuming that management could steer a firm’s cash toward profitable investment opportunities, there is no guarantee that it will. The rise in a firm’s share price after the announcement of a buyback can therefore be explained by shareholders recalculating the probability that the firm’s cash is going to be squandered on such suboptimal investments. That cash, once returned to investors, is now free to find its way into a small business loan, a growing firm’s shares, a venture capital fund, or a variety of other uses. The much-lamented fact that executive compensation is increasingly tied to share price may in fact be an efficient mechanism by which managers are incentivized to redistribute free cash flow back to shareholders instead of allocating it toward non-profit-maximizing assets.[15]

If buybacks are indeed a possible mechanism by which management can artificially meet a compensation metric (eg EPS, ROA) the problem lies in the structure of the corporate contract, not with buybacks themselves. Presumably, if managers are incurring large opportunity costs by returning cash that could have gone toward profitable investments, this will harm a firm’s share price insofar as investors downwardly adjust their expectation that these funds will be used profitably. This line of reasoning merely grants the assumption that shareholders are at least as perceptive as the critics of buybacks, who so confidently claim to know that managers are foregoing high-return investments.[16] But, having granted this assumption, management’s ability to “trick” the market via buybacks disappears, as shareholders will penalize the firm’s valuation for its unwillingness to undergo profitable investments.

Even allowing for management to systematically and repeatedly manipulate share prices via buybacks to line their own pockets to the detriment of the firm, the logic of natural selection should militate against the persistence of firms with such maladaptive compensation packages. Firms that incentivize their management to sacrifice long-term growth for the sake of juicing EPS will eventually be out-competed in the market by firms that have a more adaptive compensation structure.

Buybacks, moreover, allow firms to nimbly modify their capital structure in response to changing market conditions. As mentioned in Part I Section III, firms have been using share buybacks to rebalance their liabilities away from equity and towards debt partly in response to historically low interest rates, a “great trade” according to Home Depot’s CFO.[17] Firms also calibrate their mix of debt and equity financing as a function of expected future rates of the relative costs of capital. In raising the cost of reversing a round of equity issuance, restrictions on buybacks make forecasting errors much more painful.

One particularly ironic use toward which share buybacks might be deployed is as a defense against shareholder underpricing of a firm’s value.[18] If shareholders are systematically mispricing a firm’s shares relative to its fundamentals, perhaps by underestimating or overly discounting future growth, management can send a costly signal of its belief that the shares are undervalued by repurchasing and then reissuing them in the future for a capital gain.

      


[1] Stock Buybacks: Driving a High-Profit, Low-Wage Economy, Palldino 2018

[2] Fried and Wang 2018

[3] Id

[4] Farre-Mensa, Michaely, and Schmalz (2018)

[5] Roe 2018

[6] Supra, note 2

[7] Op-ed March 5, 2018

[8] In 1989, economist Jeremy Stein published a highly influential article titled Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior. It explicates a model in which corporate managers are trapped in a prisoner’s dilemma vis-a-vis other managers. Anticipating that investors will use current earnings as the best forecast of future earnings, each manager is eager to unilaterally inflate the next earnings report and thereby reap an advantage in attracting equity capital. This can be accomplished by relatively innocuous accounting gimmickry, or by genuinely harmful dereliction of longer-term investments. The systemic effect of these individually rational strategies is an equilibrium in which all short-term earnings are inflated but to nobody’s advantage. This is but a particular strain of a larger literature, which details the various mechanisms by which share prices may be caused to deviate from fundamentals without alleging that investors are irrational (a school of thought with a similarly impressive pedigree, with seminal contributions from Robert Shiller, Brad DeLong and Lawrence Summers).    

[9] Hall and Soskice (2000) “Varieties of Capitalism”

[10] Eg Elizabeth Warren’s Accountable Capitalism Act and the incorporation of say-on-pay mandates in the Dodd-Frank Act

[11] Rule 10b-18

[12] Lazonick (2014)

[13] Treece (2011)

[14] Jensen and Meckling (1976)

[15] Grossman and Hart 1982; Jensen 1986, 1989; Hart and Moore 1995; Hansmann 1996

[16] Palladino (2018)

[17] Ma (2016)

[18] Stein (1996)