Share buybacks: The other side of the medal

Figure 1. Buybacks are the new dividend. Reprinted from 
Financial Times, by R. Henderson, 2019, https://www.ft.com

Following the trend of the last 10 years, share buybacks remain on track to be the highest ever as companies are spending an incredible amount of over $200 billion per quarter on the corporate pay-out programs in 2019 (FT). Even though the massive payments appear to be a sign of a prosperous economy, at first sight, there seems to be another side of the medal. On 30^th July, CNN Business publishes an article called “Stock buybacks are reaching dangerous levels”, on 10^th September 2019, the Forbes magazine titles: “The Stock Buyback Disaster (And 3 Exceptions)”. This list of articles could be continued way further, and Investors ask themselves why certain academics and experts are so concerned about share repurchases which were always believed to be a positive market signal.

In order to evaluate and understand the recent media coverage, investors must understand the basics of stock buybacks. Companies have 3 ways to deal with earning profits namely reinvesting them into the firm in the form of buying new assets or paying higher wages, paying dividends to shareholders or lastly, buying shares back. Latter implies that the bought back stocks are taken from the market, decreasing the outstanding number of shares and therefore increasing the Earnings per Share as the denominator falls while the numerator stays constant. Further benefits are the already mentioned signalling because markets interpret the repurchases as believes of undervaluation, as well as observable short-term share price appreciations due to supply shocks.

In 2014, William Lazonick publishes a controversial paper stating that not tendered share buybacks are one of the major reasons why the cumulative change in per hour productivity rose significantly faster than the cumulative annual change in real per hour wages since the 1970s. The economist provides several points of critique on share buybacks which I will discuss in the following.

Figure 2. Where did the money from productivity increases go? Reprinted
from "Profits without Prosperity" by W. Lazonick, 2014, Harvard Business
Review, 92(9),  46-55

Firstly, the academic highlights that stock repurchases are positively correlated with stock prices (See Figure 2) when looking at historical data. Therefore, executives do not buy shares when they are undervalued because this would imply that buybacks are the highest in recessions. This argument doubts one common justification of buybacks but as long as markets interpret them factually as positive signals and companies are not forced to offer low price stocks in recession, the implications of this data proven refutation are not apparent to me.

Secondly, the article emphasizes that repurchases do not have any tax advantages in the US. Due to the Bush tax cuts in 2003, so-called “Qualified Dividends”, which are dividends paid by a US corporation if the stocks are owned longer than 60 days (90 for preferred stocks), are taxed at the capital gains tax rate. Therefore, one of the main arguments of buyback proponents is completely invalid and even a major conclusion of Grullon’s & Michaely’s (2002) paper, namely that taxes do matter when comparing dividends with repurchases, must be reconsidered. Surely, one could argue that the concept of qualified dividends is not universally applicable as it only exists in certain countries (for example in Germany where dividends are taxed at the same rate as capital gains), nevertheless, it has to be considered as economies like those two have a significant impact on global markets. Taking this knowledge into consideration, I further ask myself why companies are not taking advantage of the tax implications of qualified dividends as they create a strong incentive to hold the shares for a longer period.

Lastly, Lazonick gives an alternative explanation for the excessive amounts of buybacks in recent years: The fact that most of the modern-day CEOs receive a significant amount of their salary in the form of stock-based pay. Simplified, this means that they receive higher bonuses if the company succeeds to reach the threshold of certain ratios like Earning per Share. As we know that share repurchases artificially increase EPS through the decrease of the outstanding shares, this method would help the executives to reach their required targets and increase their salary without having any impact on the financial stability of their companies. The data supports his theory as the CEOs of the 10 largest repurchasers between 2003 and 2012 received an average of $168 million each in compensation during the same period while stock-based payments accounted for over 50% of those salaries. Interestingly, only 3 of those 10 companies have outperformed the S&P 500 during this period. Basically, Lazonick severely accuses all executives who participated in the enormous buyback programs of the last years of corruption if they intentionally put their own monetary interest before the company’s and shareholder’s one. This whole line of reasoning may present the strongest argument for dividends over repurchases as both may be substitutable in forms of pay-outs to the shareholders, but the latter creates strong incentives for excessive underinvestment as managers may favour short-term salary appreciations over long-term corporate growth.

In summary, there are several points provided that strongly question the amounts of share buybacks during the last decades. By his taxation argument, the economist scrutinizes the often-stated advantage of buybacks over dividends, but he is never directly criticising the usage of buybacks over dividends, rather the massive underinvestment of firms in their assets. Although, his claims indirectly state an advantage of dividends over buybacks in terms of preventing underinvestment as the latter create undesirable incentives.

Having discussed several aspects of modern shareholder pay-out policy, I now realise once again how easy it is to form and take over commonly shared opinions without questioning them. Especially when your university provides you papers and PowerPoint slides with accepted theories, I tend to forget that there are still many prestigious academics who share a completely different point of view on the same controversial topic. Although I am not overwhelmed by Lazonick’s paper as he only criticises share repurchases but does not give any data or evidence on the effect of dividends on underinvestment in pre-buy back times and how it got worse or not, it is still a recommendable paper more than worth a read for every finance interested student, academic or investor.

Bibliography

Grullon, G., & Michaely, R. (2002). Dividends, Share Repurchases, and the Substitution Hypothesis. The Journal of Finance, 57(4), 1649-1684.

Lazonick, W. (2014). Profits without Prosperity. Harvard Business Review, 92(9), 46-55.