Stock Buybacks Keep Managers From Destroying Wealth

Several weeks ago, I wrote about share buybacks. I pointed out that management’s job is to allocate capital.

It does this by reinvesting in the business, making acquisitions, rewarding shareholders or doing nothing. That’s it. There are no other uses for cash in a business.

Corporations are taxpayers and job creators. They are also unloved and often demonized. In particular, some object to massive share buybacks, which they view as anti-employee.

However, given the alternatives, I concluded that rewarding shareholders with buybacks and dividends is the best choice.

Now, I want to explain why the other choices — acquisitions and investments — both destroy wealth.

Investors Hate Acquisitions

First, let’s look at acquisitions.

A recent study looked at returns after large deals are completed. There were 1,264 acquisitions worth at least $500 million since 1998. Stock market returns six and 12 months after the acquisition are in the chart below.

Acquisitions

(Source: FactSet)

The results are clear. Large acquisitions don’t add value in the first year.

The data also shows investors don’t believe acquisitions will help in the long term. Stock prices are forward looking. Current prices reflect what investors believe a company is worth based on future performance.

First-year returns indicate investors believe companies completing acquisitions will deliver below-average results in the future.

Reinvesting in the Business Also Hurts Returns

When management reinvests in the business, there’s a built-in conflict of interest. It’s known as the principal-agent problem.

The problem is that shareholders empower managers to make decisions, but they can’t force managers to act in the shareholders’ best interest.

Managers focus on the short run. Investors focus on the long run. New investments need to deliver almost immediate results to benefit managers. But the projects often fail in the long run.

Now, if I told you this happened in government work, you wouldn’t be surprised. If I want to build a road, I might make assumptions to project a low cost. After the project starts, I will revise the estimates higher. And since I already started the project, the government agency will pay.

It’s easy to understand the problem in these terms. The same problem exists in large companies.

On Average, Buybacks Are Best

Picture the problem with a company like General Electric Co. (NYSE: GE). Over the past 10 years, management invested more than $403 billion in capital projects. These projects include initiatives like new factories or equipment upgrades.

Over that same time, the market capitalization of the stock fell by more than $250 billion. In other words, GE’s managers spent $403 billion to destroy $250 billion in wealth. Clearly shareholders would be better off if management increased the dividend.

In addition to examples like GE, there’s also research on stock prices showing the impact of the problem. On average, companies that invest the most deliver the worst returns in the long run.

One study reviewed data over 40 years. It found companies that invested the least outperformed the companies with the largest investment by an average of 20% a year.

These are averages. Some companies invest wisely. Many don’t. There’s no simple answer. But, on average, buybacks and dividends create the most wealth.

Regards,

Michael Carr, CMT
Editor, Peak Velocity Trader

8 comments

Regarding the plight that General Electric got into with the decision of what to do with the funds: They could have just increased the dividend, as suggested. But they ended up cutting the dividend this year! Had they increased it earlier, it would have just made this year’s cut much more dramatic. (Actually, they were increasing it every year over the past five years.)

Buying back stock in the open market at prices above book value is another way of destroying value. You will shrink the capital base at prices higher than the real value of the business! In the short term, this looks like management is boosting the stock price by shrinking the capital base. But where do these shares go? Usually, they end up being handed out to insiders as stock option rewards. This is like paying $50 for a tool you will turn around and hand out for $10 to a manager. Talk about value destruction! As an example, look at the record of Cisco Systems from 2005-2015; this is exactly what they did! They bought back hundreds of millions of shares, but they never shrank the shares outstanding; they just used all those shares as options rewards to their insiders.

For a quick response I’d say your article is, at best, “skewed.” In particular, only using GE as your “investment in the company” example. At minimum, you should also show Amazon as the other end of the spectrum, since AMZN became such a behemoth, both in market cap and stock price, by continually reinvesting in itself. Of course, Amazon now being a possible target for antitrust litigation (because of its size, don’t-cha-know) pretty much ruins your thesis here, but that’s also my point.

Having been a CFO of a privately held company for most of my career I can say that your analysis is wrong at multiple levels:

Regarding investing in the business you say: “Managers focus on the short run. Investors focus on the long run.” In public companies the company’s stock price is not determined by “investors” but by “traders” and traders are only interested in the short term…”what have you done for me this quarter?” Thus, trying to satisfy the “market”, managers invest to satisfy it by investing for short-term results. True investors (i.e. owners of privately held companies) have a long-term view and most of the investments they make are good ones.

Regarding acquisitions you say: “The results are clear. Large acquisitions don’t add value in the first year.” Acquisitions, even good ones, are generally not accretive in the first year. You criticize managers for investing for the short term and then criticize them for not making acquisitions that have positive results in the short term. The problem with acquisitions is that most public companies make them for the wrong reason and they end up with bad ones. During my career I made more than 20 acquisitions and more than 80% of them were accretive by the third year.

You use GE as “proof” that managers can’t make good investments. Over the past ten years GE has been trying to undo all of the damage that was done when Jack Welch turned it into a non-bank-bank and neglected investing in its core businesses. Unfortunately, that damage was so great that it now needs radical surgery to repair itself.

The study you refer to at the end uses “total assets” as the denominator of its return calculations. From an accounting standpoint, total assets include intangible assets, including goodwill. Certainly if a company overpays for an acquisition (which many public companies do) then the capitalized premium will inflate total assets. If the accounting rules changed to, say, charging the premium to equity in the year of acquisition, the study results would be different. For my money the proper “return” calculation is cash on cash. Cash is a fact, profit is an opinion…and it changes whenever the accounting rules change.

The most accurate thing that you say is “Some companies invest wisely. Many don’t. There’s no simple answer.” Amen.

Leave a Reply