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Good morning. Stock buybacks are a favourite topic of mine — thinking clearly about them requires thinking carefully about all of corporate finance. So the usual warning: what follows is super nerdy.
Does taxing buybacks make sense?
Senators Sherrod Brown and Ron Wyden want to levy a 2 per cent excise tax on stock buybacks by US public corporations. I have no idea if this has much chance of becoming law, although the New York Times reports that Democrats are “coalescing around” the idea.
The proposal touches on a crucial issue: whether public corporations are underinvesting in the real economy because of bad management incentives, and what to do about it if they are.
The senators’ press release says:
A few decades ago, a majority of Wall Street capital funded the real economy — wages, machinery, research, new construction. Today, much of that capital is funnelled back to wealthy executives in the form of stock buybacks — which used to be illegal market manipulation — and only about 15 per cent goes to the real economy. Instead of spending billions buying back stocks and handing out CEO bonuses, it’s past time Wall Street paid its fair share and reinvested more of that capital into the workers and communities who make those profits possible
Now, there is a fair amount of nonsense in there. It’s not Wall Street’s capital, but companies’ capital that funds stock buybacks. And buybacks are not market manipulation by any sane definition. But I think the Senators still might have a point.
A hypothetical example helps. Here is company X:
100 shares, trading at $10 apiece, so market cap of $1,000
The balance sheet consists of $1,000 in assets, including $50 in cash, $500 in debt and other liabilities, and $500 in shareholders’ equity
X expects net income of $50, or 50 cents per share this year
So X’s price/earnings ratio is 20, and its return on equity is 10 per cent
X spends $50 buying 5 shares of its stock on the open market. Certain things must happen:
Cash, an asset, falls by $50
Shareholders’ equity (retained earnings) falls to $450, balancing the books
Return on equity goes up to 11.1 per cent, because the company has added financial leverage; liabilities are now larger relative to equity
The share count falls to 95 and expected earnings per share goes to 52.6 cents.
Two additional things might happen:
The market might collectively decide the company’s p/e ratio should stay at 20, driving the price of the stock up to 10.53. The market cap of the company is unchanged at $1,000 (=10.53 x 95) — at the same time as anyone who still owns the shares has made a 5 per cent gain! Witchcraft!
The CEO, if his comp is linked to earnings per share, is set for a bigger bonus, despite the company making the same $50 it was going to make before the buyback! Market manipulation!
It is not witchcraft or market manipulation. Each shareholder owns more of the company now, but the company’s balance sheet is smaller than it was before, by $50. It was the market’s collective judgment, not a financial manoeuvre, that drove up the stock price. The market is saying something like “It is better to own a larger slice of company X with $50 off its balance sheet, than it is to own a smaller slice of company X with $50 on its balance sheet.” And this, if you think about it, is just the same as the market saying, “company X’s shares are worth more than $10.”
Here’s a way to see that point. Think of each of the 100 shareholders as partners in the business. The buyback is 95 of those partners saying, let’s buy out the other five partners for $10 apiece. Is that a smart thing to do? Only if the shares are worth more than $10. If business is about have an unexpected boom, the partners who stayed are smart, and the partners who sold out are dumb. If business is going to enter a shocking decline, those roles are reversed.
This same point can be made in terms of the financial leverage mentioned above. Imagine company X borrowed the money to buy back the 5 shares. That’s the 95 of the partners saying, “business is going to be strong, so we should use $50 debt financing to take out the other partners’ $50 in equity financing, this will amplify our returns, and besides, debt is tax-deductible.” If things go well, the partners who stay are smart. If things go badly and what are amplified is losses not gains, and the new debt leads to bankruptcy, then the remaining partners are dumb.
None of this is market manipulation. It is corporate finance.
Why might the market conclude that company X’s shares were undervalued, just because the company did a buyback? In theory, the market is saying something like “the board and management has just made a bet that their stock is undervalued, and they are in a good position to know, so let’s make the same bet.”
But there is an important wrinkle here. Think about the remaining partners again. They have also said something like: “the best thing we can do with our $50 is buy out our partners, which will increase our relative ownership and leverage and drive returns up by a percentage point or so.” And this is the same as saying, “there is no growth investment we could make that would increase our returns even more over time — no new branch, equipment, supercomputer or whatever. Increasing financial leverage and our ownership is the best we can do.”
After that rather long and pedantic explanation, we can say exactly what worries people like Senators Brown and Wyden. What they are worried about is that many companies do, in fact, have growth investments that would provide better returns than buybacks, but for some reason they do buybacks anyway. This is bad, because buybacks don’t contribute to economic growth, and investment does.
The standard reason for thinking companies pick the buybacks, despite higher returns from investment, is that buybacks increase EPS faster than investment does, and executives are myopic, because they are paid for performance over the short term and tend to have short tenures.
Is this bad thing, in fact, happening?
Well, we know buybacks are going up steadily. Here is buybacks by quarter for the S&P 500, going back 20 years, via Howard Silverblatt at S&P Dow Jones Indices:
We also know that tangible investment has been falling. Here is fixed capital investment as a percentage of GDP, from the US national income accounts:
There are lots of ways to slice and dice investment data, but they all mostly end up with the same trend — a decline relative to GDP since about 1980 (if you include investment in intangibles the above picture looks much better, but I think that’s a mistake).
Are the two linked? Well, I know of at least one large study, completed about a decade or two ago, suggesting that public companies — the ones with publicly traded shares to buy back and with CEOs incentivised in part for short-term EPS growth — invest less than privately held firms.
For now, though, let’s assume that companies are in fact choosing buybacks over higher-returning investment projects. Is taxing buybacks the right way to solve this problem? More on that question tomorrow.
One good read
The novelist Donald Antrim’s account of receiving electroshock therapy for suicidal depression is very moving.