What are corporate stock buybacks (also known as share/stock repurchasing programs)? Should you choose dividends or special distributions when excess capital is on the company balance sheets? This article will provide an overview of stock buybacks and both their advantages and disadvantages to shareholders.
What are Stock Buybacks?
Imagine there is a public company called ABC Enterprises. ABC has 100 shares on the open market and each share is currently valued at $10. That means it has a market cap of $1,000 (# of shares X price of each share). ABC is doing well right now, it has earnings of $0.5 / share which means it is trading at 20X earnings (price of each share / earnings of share) and had a profit of $50 (earnings per share X # of shares on the open market). Some of that money needs to go to taxes, be reinvested in the business, etc. but some of it can be used for anything the executives and shareholders see fit. They can leave it alone for a rainy day or future investment opportunity, maybe they will invest it in treasury bonds for the short term so it accumulates some interest, they can distribute it as a special one time dividend, or they can use it to purchase a few of their own shares. Until they decide what to use it for, it will sit on the balance sheet as cash.
Let’s say they decide to spend $30 repurchasing their own shares at their current price. This means there will only be 97 shares on the open market instead of 100. In theory, each share should now trade at $10.3 instead of $10, and the market cap should stay the same. The next earnings period, the company earns $50 again. This time, earnings per share will increase to $0.515 from $0.5. Everything went up by ~3% for the remaining shareholders because there are fewer shares to spread the money to! The fundamentals of the business stayed exactly the same but the results for the shareholders changed.
A History of Stock Buybacks
Share repurchasing was rarely popular historically, and has been used both to the benefit of shareholders and for shortsighted reasons. The big investment trusts of the early 20th century started to use this method more often after the initial stock market crash in 1929 to prop up their share prices. Corporate share repurchasing created the appearance of corporate decision making and actions despite merely reallocating cash from the balance sheet to share repurchases. The financial community did not approve or think it meant the company was performing better than before.
Many of our problems with stock buybacks today stem from the talking points of the financial community of the 1930s. It takes away focus on better things, it is speculative, it’s an excuse to buy shares from management/insiders, it takes away needed capital for operations, etc. All of this can be true, but is not the whole story.
Regulation Beginnings
In 1934 Congress passed the Securities and Exchange Act,meant to augment the Securities Act of 1933. The Securities and Exchange Act created the Securities and Exchange Commission (SEC)to enforce new rules and regulations. The language in the act caused stock buybacks to be considered a form of market manipulation. Although not explicitly defined as such or made illegal, stock buybacks became impractical. Repurchases were done sparingly for the following five decades.
Throughout the next five decades, companies repurchased their shares when they were confident shares were undervalued and had strong long-term value for shareholders. In other words, if management felt that the stock was cheaper than it was worth and the share buyback would both inflate the price and the value of ongoing shares more significantly than normal operations or alternative investment of excess cash would, they did this. The only other time stock repurchasing was typically used during this time period was as protection from corporate raiders. Management might repurchase their own shares as a form of defense against outsiders trying to take control.
Over time, lawsuits and public events caused confusion. While nobody was getting into severe trouble they did not want to cross the SEC. Was share repurchasing illegal? Did it merely have to be disclosed? Are more conservative stock repurchasing programs more likely to be legally acceptable?
GoGo 80’s Deregulation
In 1982 the SEC resolved confusion by issuing Rule 10b-18, creating a ‘safe harbor’ clause for companies repurchasing their own shares. Though not a legalization (stock repurchasing was never illegal), it allayed worries about potential lawsuits and established that the SEC would not pursue prosecution. The floodgates opened up, with no prosecutions since. There is not much oversight. There is very little compliance with even the voluntary requirements. It’s generally accepted that stock buybacks drive outsized stock returns for what it is. It is not changing business fundamentals, sales, the economy, or performance in any important way but can often lead to significant bumps in stock price even when used incorrectly. This constitutes market manipulation through financial tools.
A Growing and Positive Influence
Share repurchasing has become a bigger and more powerful tool over the years. To provide a simplified illustration of how big this tool has become: in 2003 companies announced roughly $115 billion in cumulative buybacks. In April of 2020 Apple had a total available capital exclusively for buybacks of $90.5 billion. In a ~5 year period Apple had produced $321 billion of cashflow and funneled 85% of it into stock repurchases.
Why use Apple as an example? They are using buybacks appropriately. Apple has a fortress of a balance sheet. They are not short on cash. Their internal hedge fund, Braeburn Capital, is one of the largest in the world with $250+ billion in AUM. They paid an average price of $160 / share, a big discount to its pre-split price. While they are prepared to spend $90 billion repurchasing their shares, they aren’t obligated to do so and will choose to buy shares only at certain prices. Moreover, Apple’s current shareholders have 25% more earning power than they had five years ago because of these buybacks. Why is this important to note? Apple hasn’t had significant earnings growth in that time. In 2015 their earnings were about $52.5 billion. In 2019 it had exploded to all of $55.3 billion. But their Earnings Per Share jumped by 29% thanks to all of those repurchases!
Share repurchasing can increase confidence in a company. It can offer a better return on capital than cash or alternative stocks or even acquisitions. If earnings stay similar or grow slightly it has benefits for the balance sheet. It can be great for both the business and its shareholders.
Problems with Power
The problem with repurchasing is that it’s a risk executives take with Other People’s Money. Shareholders might benefit enormously from stock buybacks–as they did with Apple–but they might be better off with one-time special distributions or increases to dividends, which allow shareholders to choose to purchase more shares for themselves or allocate their cash independently rather than relying on executives.
Sometimes the company itself would be better off without any form of distribution. Having cash available for new projects and unforeseen problems is good. In 2019 nobody was complaining about the massive repurchasing by airlines. By May of 2020, with hindsight, we realized they would have been better off building up their cash reserves. They overdid it by not preparing for a potential downturn. This downturn was particularly bad for the industry, but they weren’t prepared for even a month of bad business–they are relying on government support to keep employees on. Compare that to a company like Microsoft–Bill Gates instituted a rule in the 80’s which they still follow (though maybe not on purpose): always have enough cash to pay for every single employee’s salary for an entire year without any revenue. That’s a conservative play and maybe shareholders should ask for some kind of distribution!
The real problem is that repurchasing always seems to benefit company executives most. If Apple’s general shareholders did well, Tim Cook did even better. Companies issue new shares to employees and buy back those shares on the open market with repurchasing programs. There is often a significant correlation between new shares released to employees and the number of shares being acquired in a buyback, a correlation of up to 70%. Data shows that executives often time the buybacks and their sales so they can sell their own shares as the stock ‘pops’ from the announcement of a buyback. It doesn’t happen all the time but it happens often. Repurchasing can be a tool for market manipulation and personal gain for executives using Other People’s Money just as much as it is a financial tool to benefit shareholders.
Maslow’s Gavel
More often than not, long-term shareholders are better off with special distributions or dividends, or even no action, rather than stock repurchasing programs. When used correctly it is fantastic but executive managers do not have a long history of buying their stock because it is undervalued. Instead, they often start buybacks at peak stock prices, when things are going well and they can get away with anything. Even when the decision is being made for the greater good of the shareholders, many executives are not capital allocation experts. They are operators without significant stock-picking or financial experience, and as such they often choose to invest at the wrong time and price,often buying overvalued shares with the company’s cash.
For many decades Berkshire Hathaway had a fantastic policy on when to buyback shares. Their repurchase program had one major rule: buy your own stock when your market value falls below your book value. In other words–we’ll only buy our own shares when they are so cheap it would be stupid not to. If this or similar rules were followed more closely there would be fewer repurchase programs and much more value for shareholders and companies–both when repurchase programs are used and otherwise!
