Comment: pushing back against buybacks

Jul 29, 2013
<p>The buy backs argument isn&rsquo;t self-evident</p>

Particularly in the US, boards boast of ‘returning money’ to shareholders by buying back their own stock. Many regard the good sense of this tactic as being self-evident – but then, many also accepted that egregiously inflated CEO pay and adjustment of their underwater options was self-evidently to their benefit. Indeed, one suspects it is the same class of Panglossian investor that enthusiastically embraces M&A one year, divestment the next as winning strategies, and thinks refusal to pay dividends on ‘growth stocks’ is obviously in their interest.

When those growth stocks entered a catastrophic negative growth phase, many disillusioned investors wished they had dividends to invest elsewhere rather than leaving large sums to evaporate. Commentators on buybacks nod sagely as they explain the fiscal efficiency of stock repurchase over dividends because there is less tax on capital appreciation than on dividends. But what John Maynard Keynes said about economic prognostication applies to much investment analysis: its purpose is to make astrology look good.

Firstly, many investors – indeed, possibly most stockholders – are tax-exempt pension funds, endowments and not-for-profits of various kinds, which are not going to pay tax on their income. Even for those that might, however, the difference in the tax rates is so marginal as to be hardly worth worrying about, even if buybacks actually translated into visible cash for investors.

None of this is not self-evident. Theoretically, the reduction in the amount of tradable stock and the upward pressure from the purchases raise the stock price in the market, which then offers added value if and when the holder sells. Well, perhaps – but it seems a long shot, and even the paid coterie of compliant apologist analysts cannot compute a clear empirical correlation. Burning a pinch of incense on the altar of Mammon probably has as demonstrable a practical effect.

I used to think the real purpose of buybacks was to disguise the dilutive depredations on the outstanding stock of options issued to insiders. There is indeed a remarkable correlation between options and buybacks. This way the directors got a multiple halo effect: they avoid dilution, disguise the amount they are costing shareholders, and pretend to enrich the latter even as they pick their pockets.

If most of the stock bought with company money is then given away free to management, the financial effect on the market price is neutral. That does not stop people believing in the buyback effect, however. Certainly a public revelation that stock options for executives were costing the firm billions might not have been good for a company’s image or share price, as we can deduce from the hundreds of millions spent combating legislation and regulation to force firms to ‘expense’ such arrangements in the company statements. Lest we forget, ‘expensing’ was the euphemism for showing, transparently, how much executives took from shareholders.

But now there are extra reasons, and it goes deeper than even I suspected. There is indeed a quantifiable effect: reducing the number of shares increases the EPS, which might have some downstream effect on stock prices. But it definitely – and rather rapidly – clicks up progress in another part of the spreadsheet: executive options calculated on that number.

Now, call me a grouchy old cynic, but could this be a consequence of the 2006 rules mandating expensing and say-on-pay results? Needy executives then had to show they had earned the extra options they were raking in, and EPS is a plausibly solid metric to show restless shareholders, who might not notice that the S&P 500 spent $400 bn on share buybacks last year, boosting EPS to more than 6 percent, while the companies’ actual net income only grew 5 percent – and CEO options rose to record heights. I can’t help but suspect a closer statistical relationship here than between stock buybacks and rising share prices.

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