Opinion: Are share buybacks causing the stock market to shrink?
Equity markets are shrinking fast. Low borrowing costs have encouraged listed firms to pursue the largest program of share buybacks in a decade, up 9.7 percent to $45 bn in the UK alone over the past 12 months, according to Bloomberg.
Meanwhile, fewer companies have gone public for a variety of reasons, including uncertainty caused by global economic and political events and private equity funds and foreign buyers chasing cheap sterling-based acquisitions. Lower yields over the long term have meant firms can keep borrowing cheaply instead of selling shares and risk falling victim to market volatility.
We have also seen a sharp drop in the value of initial public offerings in the UK so far this year, compared with the same period in 2018, all despite the long bull run in global stock markets. In the US, companies engaged in share buyback programs totaling more than $1 tn last year – a record figure – helped by the White House’s 2017 tax overhaul. Between 2008 and 2017, more than 80 percent of corporate profits have been returned to shareholders through dividends or share buybacks.
But some have rightly questioned the logic of companies engaging in share buybacks when valuations have never been higher, as well as the use of debt to fund those buybacks. Despite arguments that money returned to investors will flow into companies that issue new shares, data compiled by the Roosevelt Institute shows that over the past 15 years this has not been the case. Meanwhile, the proportion of money spent on research and development at companies is yet to recover to pre-2008 levels.
Does management benefit more from share buybacks than shareholders?
Share buyback programs often favor company employees over shareholders. Buybacks were once viewed as a mechanism through which investors imposed discipline on companies that were sitting on too much cash. But many companies, particularly technology firms, have become used to using equity as a way to compensate staff, making share buybacks far more routine. When those staff members sell stock they have been previously awarded, it forces the company to buy the shares back to keep the share count stable.
Apple has admitted that a primary purpose of its buybacks is to neutralize the impact of staff compensation. The company has spent $151 bn on repurchasing stock in the past decade, approximately 17 percent of its $900 bn market cap. The number of its shares available to investors has dropped by around the same amount: 17 percent. When Apple started its buyback program in 2012, individual shares could be bought for half today’s price. Staff have clearly benefited from the increase in share value.
The threat from activists
Share buybacks can also leave companies vulnerable to activist investors dictating corporate asset allocation programs. Such programs can be viewed as a signal that shares are too cheap or that shareholders are unhappy with strategy or profits. Such buybacks will also impact on dividend payouts, a staple of income investors.
In one recent example, US conglomerate General Electric was halfway through a $50 bn share buyback program in 2017, as a result of pressure from activist investor Nelson Peltz, when it was forced to announce a cut to its dividend for only the second time since the Great Depression.
Are share buybacks a fig leaf on EPS growth?
Unlike dividends paid at regular intervals, companies can usually buy back stock whenever they like. Until the 1980s most companies had been reluctant to do this for fear of being accused of market manipulation. But after the Big Bang in 1986 when regulations were loosened, share buybacks soared in popularity so that by the middle of the 1990s companies increasingly began rewarding executives with stock options linked to their job performance. In the same way that share buybacks are also often used to keep the share count stable, they are sometimes used to shrink the number of shares in issue to help boost a company’s EPS ratio.
Share buyback versus special dividend
Many investors support buybacks as an exercise to clean up sellers or loose holders of the stock. They can also be a more effective way of returning capital to shareholders than a special dividend, which can be more complicated for companies with an international share register.
Little disclosure about the precise timing of buybacks is required, and the area is not one where regulators typically take action. How often do bankers properly challenge management teams on the long-term rationale of a share buyback program when they are also set to benefit from the transaction? Management has to weigh up the short-term benefits of a buyback program versus the long-term strength of the company’s balance sheet and investment program.
It may be that supporters of a buyback program are unclear on the company’s future strategy and cannot see beyond the short term. It may be that this could be resolved through an investor education program as part of a wider investor relations strategy. Although this may take longer to implement, a successful outcome can be much longer-lasting.
Fraser Thorne is the chief executive officer of Edison Group.
In part two of this article, published next week, he looks at when share buybacks have historically occurred and outlines the questions management should ask itself when considering buybacks.