Buybacks Are Nothing to Worry About

Share Buyback

Cutting taxes, for some reason, is a subject of debate.

Everyone should be happy about lower bills. But lower tax bills are emotional for many. Some people want their tax cut but object to anyone else’s tax cut. That’s especially true for corporate taxes.

Corporations are taxpayers and job creators. They are also unloved and often demonized. Tax cuts for corporations provided the latest reason to demonize corporations.

In particular, some object to massive share buybacks, which they view as anti-employee.

Buybacks Serve an Important Purpose

A share buyback occurs when a company buys its own stock. This reduces the number of shares and increases earnings per share (EPS). Higher EPS result in higher stock prices. Buybacks, in this way, contribute to higher stock prices.

Sometimes, a company is obligated to complete a share buyback.

The most important job of a company’s management team 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.

Tax cuts forced management to make decisions about how to allocate the cash companies get to keep because of lower tax rates. Bloomberg recently reported that “about 60% of the gains are going to shareholders, compared with 15% for employees.”

Share Buyback

(Source: Bloomberg)

The Bloomberg calculation counts doing nothing as rewarding shareholders.

From an accounting perspective, doing nothing increases retained earnings. That increases the book value of the company and benefits shareholders in the short run. But, eventually, companies will need to do something with that cash.

For now, companies are planning to directly return just 39% of the tax cuts to shareholders. The rest goes to investments in new business opportunities, employee benefits and philanthropy. These dollars eventually deliver rewards to shareholders because each of these expenses should increase earnings.

Buybacks Are the Last Choice for Management

Share buybacks are, in some ways, an admission of management’s failures.

Management has an obligation to use every dollar of cash flow to boost shareholder value. Ideally, managers reinvest in the business to create future wealth. Employee wages and bonuses are a form of investing in the future since employees ultimately generate revenue, profits and shareholder wealth.

When management can’t find profitable business opportunities, they have an obligation to return cash to shareholders. That’s what they’re doing with massive buybacks.

In the long run, buybacks boost earnings. In the short run, they offer an unattractive solution to the problem of slow economic growth. Large buybacks show that management doesn’t have any idea how to spend 100% of the cash from tax cuts.

They can’t simply give all the cash to employees. That would spark inflation.

Buybacks transfer money to the stock market, where much of it sits unused in the accounts of pension funds and large investors. Some investors withdraw some funds to spur additional economic growth.

Buybacks are a short-term problem. As economic growth increases, buybacks will decrease. They’re nothing to worry about.

Regards,

Michael Carr, CMT
Editor, Peak Velocity Trader

17 comments

“Employee wages and bonuses are a form of investing in the future since
employees ultimately generate revenue, profits and shareholder wealth.”

Well, good luck with that kind of sound reasoning with executives and officers of the corporation, or with shareholders. Both of those groups consider wages as a cost, not a benefit. As such, wages are treated as something to depress/suppress and “manage.” There aren’t many enlightened companies out there who see your point that increased wages, job training, and education are investments.

amen. Such idealsitic captioning sounds like so many PSAs…….but, guess what? Milions of americans buy that line–that spin–in romantic belief rather than actual practice. The essence of political polemnics….as ushered in by Madison Ave. post-ww2 advertising efficacies….

Do you have data that support your contention that most of the proceeds pension funds and other investors receive from corporate stock buybacks go unused? That seems illogical. Why would a stock owner sell a stock if he felt his best use of the proceeds would be sit on the cash?

I should have worded this better. Proceeds of pension funds and institutions are generally used in the future rather than in the present. The ultimate goal of investing is to boost consumption. Reinvesting in other stocks or holding cash do not boost consumption from an economic perspective. I hope that clarifies my thinking.

Do you really believe that “the ultimate goal of investing is to boost consumption”? Seems to me the ultimate goal of investing is to increase wealth, which in turn results from innovation and improved productivity of capital and work. Only if that occurs can GPD per capita and consumption per capita increase. Also, don’t you think companies will compete away some or all of their reductions in tax rates, reducing prices and increasing consumption?

Yes, I do believe consumption is the ultimate goal of investing because I find the consumption-based CAPM to be compelling. But, that’s semantics and I should have thought through my word choice before replying. We are saying the same thing using different words since the expenses associated with innovation and improved productivity are consumption under that model.

Will companies compete away some of the savings? That’s an open question. Companies, on average, have done a remarkable job maintaining profit margins at record levels in the past few years. It’s true across industries and it appears competitive pressures could be decreasing, maybe because of the rise of index funds and a tendency towards more homogeneous executive compensation policies. It would be nice to see lower prices but that’s not what we’ve see. (Official inflation data hides price hikes with a variety of techniques.) I’m not betting on lower prices any time soon.

I am sorry that I keep generating questions with my word choices. I answer comments directly, without an editor, and this does demonstrate how hard my editors work to make my ideas readable. CAPM is the capital asset pricing model. It’s an academic view of risk in the market place that has been refined to help explain price changes. I’m not an academic so I look for ways to use the models in the stock market. The simplest form of the CAPM is useful for measuring the relative strength of stocks and more refined versions of the model are useful when forecasting long-term price targets.

Buybacks are NOT primarily for the benefit of stockholders. This is a myth insiders want everyone to believe. They are primarily for the benefit of company insiders who receive stock bonuses and options. Stockholders benefit more directly if profits are passed on to them as dividends. And if they either buybacks or dividend boosts are done with borrowed money they increase the company’s debt level, perhaps even endangering the future of stockholders’ investments. Be suspicious of any company announcing a buyback, and examine the matter closely.

You are thinking like Warren Buffett who said he won’t pay dividends because he knows how to use capital better than his shareholders and that’s why they invest with him. In other words, dividends and buybacks are a last resort because management should use the money to boost future cash flows. Payments to shareholders through buybacks benefit shareholders by removing money from management that could otherwise be wasted (the problem that exists when agents run companies for principal the investors).

Notice I said company profits should be passed on to investors as dividends. Of course, if capital improvements would benefit the company, that should come first – they will ultimately benefit the stockholders. But stockholders are owners of the company and should come before the insiders. Buybacks are primarily for the benefit of the insiders, not the owners of the company.

Amen….was wondering when somebody mentioned who really benefits from buybacks. I do understand why most US cos. are not re-investing/building out/expanding……because we 80% people are kinda credit maxed out, or just paying those higher loans and ordinary, daily living costs–which frankly, have gone up way more than your FED reporting metrics (inflation numbers-not inclusive of real costs…) — and thus we are rather moribund with forward consumer buying–what with our lack of commensurate wage/salary increases-save those upper mgr. and 1-10% class………whose bonus remains intact and, yes, is scaled upwards reflective of share price boosted by buybacks……

60% of buyback gains to shareholders may seem large until you realize that only 10% of Americans own 80% of stock shares. That equates to gains for 60% of the 10%. Not so impressive.The fact that giving too much to employees may result in inflation does not justify giving them nothing. 90% of corporations thus far indicate they have no plans to increase wages and other benefits to ordinary employees.So what ever positive effect buybacks will have on stock market will only benefit a few at the top. Wall Street is not the economy as we have seen in the fact that stocks have recovered brilliantly since the Great Recession while wages have remained flat. The tax cut that makes the accelerated buybacks possible has further increased the Gilded Age style economic inequality already present in US. Corporations seem to forget that their success is linked to the condition of the bottom 80% that buys their products and services. Corporations and Wall Street will not thrive in an environment where fewer and fewer of the bottom 80% will be able to afford their products. That is the world we in America continue to rush toward.

Linda, I completely agree with your last two sentences. In the early 20th century, Henry Ford was smart enough to boost the pay of his employees, so that they could afford to by his products – at least with a bit of debt. Now, though, debt has gotten completely out of hand.

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