Stock Buybacks Are Not the Enemy
Are share buybacks really one of America’s biggest economic problems? You’d certainly think so if you believe the astoundingly kindred attacks coming from both sides of the aisle in Congress.
On Tuesday, the Senate progressives assaulting share repurchases gained a prominent ally from the GOP ranks in what’s now a bi-partisan campaign radically alter the way companies reward investors. Senator Marco Rubio (R-Fla), who’s generally pro-business, and Chuck Schumer (D-NY) and Bernie Sanders (I-Vt), don’t agree on much, but they’ve locked arms in targeting share repurchases as an enemy of the American worker and a principal driver of income inequality. Though the two camps advocate different solutions, they’re aiming at a common objective: Clamping down on buybacks. In their view, no reform would do more to make the U.S. economy both fairer, and more productive.
The reality is the precise opposite: Repurchases channel corporate earnings from old-economy stalwarts lacking profitable places to reinvest the cash to the industries of the future. “Shareholders get the money from companies with no compelling projects for future growth, and get to invest it in the next Apple or Amazon,” says Rob Arnott, chief of Research Affiliates, a firm that oversees investment strategies for $170 billion in mutual funds and ETFs. Repurchases furnish capital that private equity deploys to reinvigorate under-performers, that the venture capital community raises to launch a Facebook or Snap, and that IPOs provide to take disruptors to the next phase of disruption. It’s the cash distributed by a P&G or GM that, through this fluid ecosystem, funds expansion in fast-growers hungry for capital, in areas from cloud-based services to e-commerce distribution centers to electric cars. When those young companies hit their stride, they tend to generate the extra-robust sales and profits per worker. Put simply, shareholders’ freedom to direct cash to its highest and best use drives productivity, and it’s rising productivity that swells paychecks.
The Rubio and Schumer-Sanders plans would disrupt that dynamic, unleashing unintended consequences that would result in the opposite of their avowed goals. “It’s a circulatory system of veins and arteries that pulls cash in and pumps cash out,” says Bennett Stewart, senior advisor to ISS, the corporate governance and shareholder advisory firm. “The proposed rules would block the system by putting tourniquets all around.”
On Tuesday, the Senate Small Business Committee, chaired by Rubio, released the Senator’s tentative buyback proposal as part of a battle plan for countering China’s drive for global dominance (“Made in China 2025 and the Future of American Industry”). Rubio’s target is the tax preference that favors buybacks over dividends. Companies often choose returning cash to shareholders via buybacks because their shareholders pay about half the rate on income received through repurchases that they’d owe on quarterly payouts. Shareholders owe regular federal income tax on dividends, to a maximum federal rate of 39.6%. But say a company decides that instead of paying $1 billion in dividends from this year’s earnings, equivalent to the value of 2% of its shares outstanding, it will repurchase 2% of its shares instead, in a transaction that also costs $1 billion. Overall, its stockholders get $1 billion in cash for selling their shares in the repurchase offer, the same amount they’d receive in dividends. But instead of paying almost 40% in federal taxes on dividends classified as ordinary income, if they’ve held the shares for over a year, they benefit from the long-term capital gains levy of 20%.
In tax the policy section of the new report, the the Florida senator suggests raising America’s capital gains tax so that the treatment of dividends and buybacks is more equal. He doesn’t specify the new rate, but does state that the higher levy would apply only to gains from repurchases, not to all capital gains. It’s not the first time Rubio has skewered buybacks. As he tweeted in December, “When a company uses profit for stock buyback, it’s deciding that returning capital to shareholders is better for business than investing in their products or workers.” He reprises the theme in the new report, labeling repurchases as “a non-productive alternative(s) to capital investment” that makes possible “a world of higher asset prices, lower investment in the economy, and lower worker pay.” The report goes on to contend that “cash spent on share repurchases are not cash spent on capital investment.” Rubio stops an inch short of definitively proposing a higher cap gains rate by stating that “tax policy changes to end this preference might, on their own, increase investment by shifting shareholder appetite for capital return.” Despite the hedge, it’s clear that Rubio despises buybacks, and highly probable that his praise for curtailing them via higher taxes will soon be enshrined in new proposed legislation.
Schumer and Sanders unveiled their manifesto 10 days earlier in a New York Times editorial. The pair join Rubio in blaming an extraordinary proportion of what they perceive as an economy failing most Americans on this narrow target. They write that repurchases act “to the detriment of workers and long-term strength of their companies,” and “are helping to create the worst levels of income inequality in decades.” Their solution: Legislation that would outlaw buybacks unless corporations agree to “things like” raising minimum pay to at least $15 an hour, granting seven days of paid sick leave, and providing “more reliable health care benefits,” and “decent pensions.” Those policies, they contend, would incentivize “productive investment of corporate capital.”
To be fair, buybacks aren’t without drawbacks. When a CEO’s compensation is tied to earnings-per-share, he or she can collect bigger bonuses and stock grants by simply orchestrating repurchases that lower the float and inflate EPS, a process that just shifts cash around without creating any new value for shareholders. Boards, however, can eliminate the problem by scuttling EPS as a metric for comp. Another downside: In recent years, companies have been borrowing heavily to fund buybacks, depleting equity and increasing their leverage, and hence raising the risk shouldered by investors.
The two plans have different shortcomings, but share one big one: The assertion that the cash from buybacks is somehow wasted, rather than invested, when it’s really funneled to capex that yields a lot more profit than if CEOs who generated the earnings kept the money. The Schumer-Sanders manifesto combines factual errors on the size and shareholder-enriching power of buybacks, and a misconception that forcing companies to retain far more earnings, or spend what they now pay for buybacks on extra pay and benefits, would create durable increases in employment and incomes.
The first inaccuracy is the claim that buybacks automatically result in “boosting the value of the stock.” In reality, repurchases simply trade cash, an asset owned by shareholders, for a reduction in the share count that increases the value of their ownership in the enterprise by exactly the amount. I’ve created the following scenario based on an example used John Cochrane, an economist at Stanford’s Hoover Institution. Consider a company we’ll called Buyback Ventures that holds two assets, $100 in cash, and a $100 investment in a profitable plant, and no debt. Buyback Ventures has two shares outstanding, each worth $100. Both shares are owned by an investor we’ll call Henry, an acronym for “High Earners Not Rich Yet,” that this writer coined several years ago. Buyback Ventures repurchases one of Henry’s two shares for $100.
There’s no reason for Buyback’s stock to jump: It’s shifted the $100 in cash on its balance sheet that’s effectively owned by Henry to pay Henry $100 for one of his shares. Henry used to have $200 in stock. Now he has $100 in cash and $100 in stock. “It’s a wash,” writes Cochrane.
Of course, shares often spike on buyback announcements that aren’t expected, or especially, if a company unveils plans to return a much larger portion of its earnings to shareholders, via repurchases or dividends, in the future. A buyback-bump signals that investors endorse the company’s view that its shareholders can invest a bigger chunk of profits on their own, at higher returns than the company can generate by keeping the money. It’s not the buyback per se that lifted the stock, it’s the perception that the company is a good steward of capital, and will retain the right amount of cash to fund profitable growth, and no more.
Second fact-check: The editorial strongly, and wrongly, implies that America’s big companies are reinvesting, at best, a tiny fraction of their profits. Schumer and Sanders write that “between 2008 and 2017, the S&P 500 companies spent $4 trillion on buybacks, equal to 53 percent of profits,” and an additional 40% on dividends, meaning that “More than 90% of corporate profits go to buybacks and dividends.” The senators didn’t give a specific number for dividends and repurchases in 2018, but they’re suggesting that the combination regularly absorbs over 90% of total profits, leaving less than 10% for retained earnings, the category where they want most profits to go. If the “90%-plus” scenario were accurate, the 500––which earned $1.2 trillion in 2018––would have retained a piddling $120 billion or less last year.
The real number is three-times that amount, or $350 billion, amounting last year to 32% of S&P earnings. The authors wrongly assume that all buybacks are funded by profits, and what’s left over after dividends is all that’s reinvested. That’s fake math. The reason buybacks and dividends can add up to the 90%-plus figure is that the 500 borrows a huge portion of the cash spent on buybacks; so those purchases are funded by extra debt, not new earnings. Once again, all that borrowing is problematic since is greatly raises leverage––and risk. In 2018, for example, borrowing funded 56% of the record $800 billion in repurchases, according to data compiled by Yardeni Research.
The authors aren’t just wrong in asserting that buybacks artificially enrich investors; they’re also incorrect in suggesting that they substantially shrink the number of shares outstanding, the process that’s supposed to create tons of wealth. Last year, buybacks did lower the total “float” in the S&P 500 by around 3%. But that’s highly unusual. Companies are constantly issuing new shares for stock grants, convertible bond offerings and secondary equity offerings, and as currency for dilutive acquisitions. Arnott’s research demonstrates that over the past twenty years, S&P 500 buybacks have exceeded new stock issuance by just 1%. But add in small and mid-sized companies, and the picture changes radically. “The entire U.S. stock market has seen net dilution in EPS averaging 2% a year,” says Arnott. “Meaning companies are typically issuing 2% more shares than they’re buying back.”
So in pressing their campaign, the anti-buyback forces are really saying that investors should accept rates of dilution much higher than 2%, so that companies can keep a lot more of the cash they generate each year, cash that belongs to shareholders. “In that case, they’d be paying for compensation for CEOs and other top managers by seeing their ownership diluted, and at the same time letting those CEOs keep the cash,” says Arnott. He concludes that “buybacks aren’t nearly the big deal critics claim because in most years, they don’t offset dilution and decrease the total ‘float.'” Their real contribution: preventing much deeper dilution by denying shareholders the cash, and handing management a much bigger chunk of America’s earnings to use as they please.
Rubio’s tentative proposal isn’t coercive like the Schumer-Sanders plan. But it since it would raise cap gains rates on buybacks closer to the levy on dividends, neither companies nor investors would have much incentive to pay or demand repurchases. “What the change really does it raise the cost of capital by taxing it more heavily,” says Stewart. “So companies would buy back a lot less stock, the route that now offers investors the highest after-tax returns, and hold onto the money. The problem is there’s an old expression, when cash is burning a hole in a company’s pocket, they don’t tend to invest it wisely. When a company keeps cash, it’s denying capital to another company that may be able to use it a lot better.”
So how profitably does the c-suite marshal retained earnings, the category that the senators want to greatly expand? Arnott states that contrary to the Schumer-Sanders view, companies that retain big portions of their earnings grow a lot more slowly than those that return most of the profits to shareholders––meaning they squander a lot of those retained earnings. That’s the finding of an influential study that Arnott conducted in 2003 with one of America’s leading asset managers, Cliff Asness, co-founder of hedge fund titan AQR Capital (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=390143). In other words, companies that pay out a relative high portion of profits achieve higher returns on the cash they keep than those that hold onto more of the cash.
The U.S. economy is divided between two general categories of companies: Mature players that generate lots of cash but plod along slowly, the Campbell’s Soups and P&Gs of this world, and the fast-growers from Tesla to Facebook that are hungry for capital. And since automakers, steel producers and other old-economy giants generate far more cash than profitable places to invest it, the best course for the growth is handing big chunks of earnings to shareholders. What do investors do with the money from buybacks? “They typically don’t spend it on vacations and restaurants,” says Cochrane. “That’s money they need to invest.” The cash from buybacks generally doesn’t go to shopping at the mall, but seeks the highest returns available in anything from super-computing, or drones that survey sprawling farms, pinpointing fields that need irrigation or fertilizer, and relaying the data to the owners’ laptops.
What would happen if companies were either forced to keep the money, the Schumer-Sanders solution, or had little incentive to buy back stock because a new tax just raised the cost of returning cash to shareholders, the Rubio prescription? “Many older companies now already waste a lot of retained earnings,” says Cochrane. “If they got to keep more, they’d waste even more on empire building, on management glorification projects. They won’t just sit on the cash, they’ll try to get bigger by overpaying for acquisitions or building new factories in dying industries. The bigger a company becomes, the more its CEO usually makes.” Arnott echoes his view: “What do Sanders and Schumer want companies to do? Retain a lot more income and spend it on dumb ideas? That’s what buybacks are intended to stop.”
Cochrane, Arnott and Stewart all agree that it’s today’s freedoms that embolden shareholders, including large institutions, to pressure mature businesses to return a large portion of their earnings in dividends and buybacks. “The 30%-plus that companies now reinvest is fully sufficient,” says Arnott. “They don’t need more.” Adds Stewart: “It’s the shareholder pressure to return capital that prevents companies from wasting their money.”
Schumer and Sanders want to channel cash in the opposite direction, from investment that enhances productivity to consumer spending that does little to raise output per workers. “Wouldn’t it be better for our national economy,” they ask, “if instead of buying back stock, corporations paid all of their workers better wages and provided good benefits?” It certainly sounds as though they’re advocating that companies take the the 30% of profits that now go to buybacks, and use those dollars to raise pay and benefits. It won’t work. Companies that accept much lower profits, and profitability, would rapidly decline since investors will deny them the capital not just to grow, but even to replace existing plants, fabs and warehouses. More likely, If profits suddenly shrink, corporate America will slash jobs a record rate to recoup earnings from lower head-counts. Some workers who make the a newly mandated, $15 a hour minimum wage, might pocket higher pay. But but far fewer would be employed, and pressure to rescind the raises would be intense. “The notion that ending buybacks would go to workers in the form of raises is a pipe dream,” says Arnott. “A vibrant jobs market determines when employees are going to get raises, as is the case right now.”
Restricting buybacks would provide a case study in inviting disastrous unintended consequences. Stand by for an explosion in dealmaking as veterans flush with cash, and no place to put it in their slow-growth core businesses, expand by overpaying for for acquisitions in far-flung fields. The Schumer-Sanders solution would also pummel federal tax revenues, since the capital gains generated from shareholders who willingly sell their shares in buyback offerings would disappear. Public ownership is becoming increasingly unappealing for newly-created companies. As Arnott points out, over the past twenty years, the total number of enterprises whose shares are publicly traded has shrunk from 7000 to 3500. That’s deprived America’s investors from access to shooting stars that prefer to remain private. “Do the politicians want to give businesses yet another reason to shun joining the publicly traded marketplace?” asks Arnott. The senators are making a huge deal out of the alleged scourge of buybacks, when curtailing them would be the really big deal. And a raw deal for America’s workers.