Wednesday, July 01, 2015

Do stock buybacks enrich CEOs at the expense of the economy?

Are share buybacks hurting the economy and increasing income inequality? 

Some pundits seem to think so. There was an article in Harvard Business Review, a while ago, which might have been an editorial (I can't find a byline). That followed a similar article from FiveThirtyEight, that concentrated on the economic effects. When I Googled, I came across another article from The Atlantic. I think it's a common argument ... I'm pretty sure I've seen it lots of other places, including blogs and Facebook.

They think it's a big deal, at least going by the headlines: 


-- "How stock options lead CEOs to put their own interests first" (Washington Post)

-- "Stock Buybacks Are Killing the American Economy" (The Atlantic)

-- "Profits Without Prosperity" (Harvard Business Review)

-- "Corporate America Is Enriching Shareholders at the Expense of the Economy" (FiveThirtyEight)

But ... it seems to me that neither the "hurt the economy" argument nor the "increase inequality" argument actually makes sense.

Before I start, here's a summary, in my own words, of what the three articles seem to be saying. You can check them out and see if I've captured them fairly.


"Corporations have always paid out some of their earnings in dividends to shareholders. But lately, they've been dispersing even more of their profits, by buying back their own shares on the open market. 

"This is problematic in several ways. For one, it takes money that companies would normally devote to research and expansion, and just pays it out, reducing their ability to expand the economy to benefit everyone. In addition, it artificially boosts the market price of the stock. That benefits CEOs unfairly, since their compensation includes shares of the company, and provides a perverse incentive to funnel cash to buybacks instead of expanding the business.

"Finally, it makes the rich richer, boosting the stock values for CEOs and other shareholders at the expense of the lower and middle classes."

As I said, I don't think any part of this argument actually works. The reasons are fairly straightfoward, not requiring any intricate macroeconomics.

-----

1. Buybacks don't increase the value of the shares

At first consideration, it seems obvious that buybacks must increase the value of your stockholdings. With fewer shares outstanding, the value of the company has to be split fewer ways, so your piece of the pie is bigger.

But, no. Your *fraction* of the pie is bigger, but the pie is reduced in size by exactly the same fraction. You break even. That *has* to be the case, otherwise it would be a way to generate free money!

Acme has one million (1 MM) shares outstanding. The company's business assets are worth $2 MM, and it has $1 MM in cash in the bank with no debt. So the company is worth $3 a share.

Now, Acme buys back 100,000 shares, 10 percent of the total. It spends $300,000 to do that. Then, it cancels the shares, leaving only 900,000.

After the buyback, the company still owns a business worth $2 million, but now only has $700,000 in the bank. Its total value is $2.7 million. Divide that by the 900,000 remaining shares, and you get ... the same $3 a share as when you started.

It's got to be that way. You can't create wealth out of thin air by market-value transactions. 

The HBR author might realize this: he or she hints that buybacks increase stock prices "in the short term," and "even if only temporarily."  I'm not sure how that would happen -- for very liquid shares, the extra demand isn't going to change the price very much. Maybe the *announcements* of buybacks could boost the shares, by signalling that the company has confidence in its future. But that's also the case for announcements of dividend increases.

One caveat: it's true the share price is higher after a buyback than a dividend, but that's not because the buyback raises the price: it's because the dividend lowers it. If the company spends the $300,000 on dividends instead of buybacks, the value of a share drops to $2.70. The shareholders still have $3 worth of value: $2.70 for the share, and 30 cents in cash from the dividend. (It's well known, and easily observed, that the change in share price actually does happen in real life.)

If the CEO chooses to spend the cash on buybacks, then, yes, the stock price will be higher than if he chose to spend it on dividends. It won't just be higher in the short term, but in the long term too. 

Are buybacks actually replacing dividends? The FiveThirtyEight article shows that both dividends and buybacks are increasing, so it's not obviously CEOs choosing to replace one with the other. 

But, sure, if the company does replace expected dividends with buybacks, the share price will indeed sit higher, and the CEO's stock options will be more valuable.

To avoid conflicts of interest, it seems like CEOs should be compensated in options that adjust for dividends paid. (As should all stock options, including the ones civilians buy. But they don't do that, probably because it's too complicated to keep track of.)  But, again: the source of the conflict is not that buybacks boost the share price, but that dividends reduce it. If you believe CEOs are enriching themselves by shady dealing, you should be demanding more dividends, not decrying buybacks.


2. The buyback money is still invested

The narratives claim that the money paid out in share buybacks is lost, that it's money that won't be used to grow the economy.

But it's NOT lost. It's just transferred from the company to the shareholders who sell their stock. 

Suppose I own 10 shares of Apple, and they do a buyback, and I sell my shares for $600 of Apple's money. That's $600 that Apple no longer has to spend on R&D, or advertising, or whatever. But, now, *I have that $600*. And I'm probably going to invest it somewhere else. 

Now, I might just buy stock in another company -- Coca-Cola, say -- from another shareholder. That just transfers money from me to the other guy -- the Coca-Cola Corporation doesn't get any of that to invest. But, then, the other guy will buy some other stock from another guy, and so on, and so on, until you finally hit one last someone who doesn't use it to buy another stock.

What will he do? Maybe he'll use the $600 to buy a computer, or something, in which case that helps the economy that way. Or, he'll donate the $600 to raise awareness of sexism, to shame bloggers who assume all CEOs and investors are "he". Or, he'll use it to pay for his kids' tuition, which is effectively an investment in human capital. 

Who's to say that these expenditures don't help the economy at least as much as Apple's would?

In fact, the investor might use the $600 to actually invest in a business, by buying into an IPO. In 2013, Twitter raised $1.8 billion in fresh money, to use to build its business. It's quite possible that my $600, which came out of Apple's bank account, eventually found its way into Twitter's.

Is that a bad thing? No, it's a very good thing. The market judged, albeit in a roundabout way, that there was more profit potential for that $600 in Twitter than in Apple. The market could be wrong, of course, but, in general, it's pretty efficient. You'd have a tough time convincing me that, at the margin, that $600 would be more profitable in Apple than in Twitter.

The economy grows the best when the R&D money goes where it will do the most good. If Consolidated Buggy Whip has a billion dollars in the bank, do you really want it to build a research laboratory where it can spend it on figuring out how to synthesize a more flexible whip handle? 

At the margin, that's probably where Apple is coming from. It makes huge, huge amounts of profit, around $43 billion last year. It spent about $7 billion on R&D. Do we really want Apple to spend six times as much on research as we think is appropriate? It seems to me that the world is much better off if that money is given back to investors to put elsewhere into the economy.

That might be part of why buyback announcements boost the stock price, if indeed they do. When Apple says it's going to buy back stock, shareholders are relieved to find out they're not going to waste that cash trying to create the iToilet or something.


3. Successful companies are not restrained by cash in the bank

According to the FiveThirtyEight article, Coca-Cola spent around $5 billion in share repurchases in 2013. But their long-term debt is almost $20 billion.

For a company like Coca-Cola, $20 billion is nothing. It's only twice their annual profit. Their credit is good -- I'm sure they could borrow another $20 billion tomorrow if they wanted to.

In other words: anytime the executives at Coke see an opportunity to expand the business, they will have no problem finding money to invest. 

If you don't believe that, if you still believe that the $5 billion buyback reduces their business options ... then, you should be equally outraged if they used that money to pay down their debt. Either way, that's $5 billion cash they no longer have handy! The only difference is, when Coca-Cola pays down debt, the $5 billion goes to the bondholders instead of the shareholders. (In effect, paying off debt is a "bond buyback".)

The "good for the economy" argument isn't actually about buybacks -- it's about investment. If buybacks are bad, it's not because they're buybacks specifically; it's because they're something other than necessary investment.

It's as if people are buying Cadillac Escalades instead of saving for retirement. The problem isn't Escalades, specifically. The problem is that people aren't using the money for retirement savings. Banning Escalades won't help, if people just don't like saving. They'll just spend the money on Lexuses instead.

Is investment actually dropping? The FiveThirtyEight article thinks so -- it shows that companies' investment-to-payout ratio is dropping over time. But, so what? Why divide investment by payouts? Companies could just be getting rid of excess cash that they don't know what to do with (which they also get criticized for -- "sitting on cash"). Looking at Apple ... their capital expenditures went from 12 cents a share in 2007, to $1.55 in 2014 (adjusted for the change in shares outstanding). A thirteen-fold increase in research and development doesn't suggest that they're scrimping on necessary investment.


4. Companies offset their buybacks by issuing new shares

As I mentioned, the FiveThirtyEight article notes that Coke bought back $5 billion in shares in 2013. But, looking at Value Line's report (.pdf), it looks like, between 2012 and 2013, outstanding shares only dropped by about half that amount.

Which means ... even while buying back and retiring $5 billion in old shares, Coca-Cola must have, at the same time, been issuing $2.5 billion in *new* shares. 

I don't know why or how. Maybe they issued them to award to employees as stock options. In that case, the money is part of employee compensation. Even if the shares went to the CEO, if they didn't issue those shares, they'd have to pay the equivalent in cash.

So if you're going to criticize Coca-Cola for wasting valuable cash buying shares, you also have to praise it, in an exactly offsetting way, for *saving* valuable cash by paying employees in shares instead. Don't you?

I suppose you could say, yes, they did the right thing by saving cash, but they could do more of the right thing by not buying back shares! But: the two are equal. If you're going to criticize Coca-Cola for buying back shares, you have to criticize other companies that pay their CEOs exclusively in cash. 

But the HBR article actually gets it backwards. It *criticizes* companies that pay their CEOs in shares!

Suppose Coca-Cola is buying back (say) a million shares for $40 MM, which is presumably bad. Then, they give those shares to the employees, which is also presumably bad. Instead, the Harvard article says, they should take the $40 MM, and give it to the employees directly. 

But that's exactly the same thing! Either way, Coca-Cola has the same amount of cash at the end. It's just that in one case, the original shareholders have shares and the CEO has cash. The other way, the original shareholders have the cash and the CEO has the shares.

What difference does that make to the economy or the company? Little to none.


5. Inequality is barely affected, if at all

Suppose a typical CEO makes about $40 million. And suppose half of that is in stock. And suppose, generously, that the CEO can increase the realized value of his shares by 5 percent by allegedly manipulating the price with share buybacks.

You're talking about $1 million in manipulation. 

How much does that affect inequality? Hardly at all. The top 1% of earners in the United States are, by definition, around 3 million people. That includes children ... let's suppose the official statistics use only 2 million people.

The Fortune 500 companies are, at most, 500 CEOs. Let's include other executives and companies, to get, say, 4,000 people. 

That's still only one-fifth of one percent of the "one percenters."

The average annual income of the top 1% is around $717,000. Multiply that by two million people, and you get total income of around $1.4 trillion.

After the CEOs finish manipulating the stock price, the 4,000 executives earn an extra $4 billion overall. So the income of the top 1% goes from

$1,400,000,000,000

to 

$1,404,000,000,000

That's an increase of less than one-third of one percent. Well, yes, technically, that does "contribute" to inequality, but by such a negligible amount that it's hardly worth mentioning. 

And that .00333 percent is still probably an overstatement:

1. We used very generous assumptions about how CEOs capitalize on stock price changes. 

2. When the board offers the CEO stock options, both parties are aware of the benefits of the CEO being able to time the announcements. Without that benefit, pay would probably have to increase (for the same reason you have to pay a baseball player more if you don't give him a no-trade clause). So, much of this alleged benefit is not truly affecting overall compensation.

3. Price manipulation is a zero-sum game. If the executives win, someone loses. Who loses? The investors who buy the executives' shares when they sell. Who are those investors? Mostly the well-off. Some of the buyers might be pension funds for line workers, or some such, but I'd bet most of the buyers are upper middle class, at least. 

We know for sure it isn't the poorest who lose out, because they don't have pension funds or stocks. So it's probably the top 1 percent getting richer on the backs of the top 10 percent.

--------

Here's one argument that *does* hold up, in a way: the claim that buybacks increase earnings per share (EPS).

Let's go back to the Acme example. Suppose, originally, they have $200,000 in earnings: $190,000 from the business, and $10,000 from interest on the $1 MM in the bank. With a million shares outstanding, EPS is 20 cents.

Now, they spend $300K to buy back 100,000 shares. Afterwards, their earnings will be $197,000 instead of $200,000. With only 900,000 shares remaining outstanding, EPS will jump from 20 cents to 21.89 cents.

Does that mean the CEO artificially increased EPS? I would argue: no. He did increase EPS, but not "artificially."

Before the buyback, Acme had a million dollars in the bank, earning only 1 percent interest. On the other hand, an investment in Acme itself would earn almost 7 percent (20 cents on the $3 share price). Why not switch the 1-percent investment for a 7-percent investment? 

It's a *real* improvement, not an artificial one. If Acme doesn't actually need the cash for business purposes, the buyback benefits all investors. It's the same logic that says that when you save for retirement, you get a better return in stocks than in cash. It might be right for Acme for the same reason it's right for you.

Does the improvement in EPS boost the share price? Probably not much -- the stock market is probably efficient enough that investors would have seen the cash in the bank, and adjusted their expectations (and stock price) accordingly. A small boost might arise if the buybacks are larger, or earlier, than expected, but hardly enough to make the CEO any more fabulously wealthy than he'd be without them.

------

There's another reason companies might buy back shares -- to defer tax for their shareholders.

Suppose Coca-Cola has money sitting around. They can pay $40 to me as a dividend. If they do, I pay tax on that -- say, $12. So, now, I have $12 less in value than before. The value of my stock dropped by $40, and I only have $28 in after-tax cash to compensate.

Instead of paying a dividend, Coke could use the $40 to buy back a share. In that case, I pay no tax, and the value of my account doesn't drop.  

Actually, the buybacks are just deferring my taxes, not eliminating them. When I sell my shares, my capital gain will be $40 more after the buyback than it would have been if Coke had issued a dividend instead. As one of the linked articles notes, the US tax rate on capital gains is roughly the same as on dividends. So, the total amount is a wash -- it's just the timing that changes.

Maybe that tax deferral bothers you. Maybe you think the companies are doing something unfair, and exploiting a loophole. I don't agree; for one thing, I think taxing corporate profits, and also dividends, is double taxation, a hidden, inefficient and sometimes unfair way to raise revenues. (Companies already have to pay corporate income tax on earnings, regardless of whether they use it for buybacks, dividends, reinvestment, or cash hoards.)

You might disagree with me on that point.  If you do, then why aren't you upset at companies who don't pay dividends at all? If share buybacks are a loophole because they defer taxes, then retained earnings must be a bigger loophole, because they defer even *more* taxes!

Keep in mind, though, the deferral from buybacks is not quite as big as it looks. When the company buys the shares, the sellers realize a capital gain immediately. If the stock has skyrocketed recently, the total tax the IRS collects after the buyout could, in theory, be a significant portion the amount it would have collected off the dividend. (For instance, if all the selling shareholders had originally bought Coca-Cola stock for a penny, the entire buyback (less one cent) would be taxed, just as the entire dividend would have been.)

There's another benefit: when Coca-Cola buys shares, it buys them from willing sellers, who are in a position to accept their capital gains tax burden right now. That's the main advantage, as I see it: the immediate tax burden winds up falling on "volunteers," those who are able and willing to absorb it right now.

-------

In my view, buybacks have little to do with greedy CEOs trying to enrich themselves, and they have negligible effect on the economy compared to traditional dividends. They're just the most tax-efficient way for companies to return value to their owners.




UPDATE: Finance writer Michael Mauboussin explains buybacks in more detail in a FAQ here.  (Mauboussin has also written about sports and luck.)


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14 Comments:

At Friday, July 31, 2015 10:39:00 PM, Blogger Danny Dye said...

Great article. There are two factors regarding the effect on executive earnings,

1. When they are paid in salary, the dollars will be taxed at regular tax rates. Probably pretty high in these cases. When given stock, the money is taxed as long term capital gains. This will be 15% to 20% currently. Normally this is less than the income tax rate.

2. When they are paid in salary, the company must pay 1/2 of the Social Security $'s due on the income.

Most of the time stock is a better option than salary (cash) for both parties.

Danny

 
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