Share buybacks weren’t the dilemma of The Clash’s 1980s hit song. But they did lament: “If I go, there will be trouble; And if I stay it will be double.” What to do?
Share buybacks occur because companies have a good amount of excess cash and the best way to spend the money, many executives and directors reason, is to buy back its shares. “We’ll be putting money directly in shareholders’ pockets and at the same time, we’re increasing shareholder value,” is the boilerplate explanation.
“Putting money in shareholders’ pockets” is just one option a company has for spending excess cash. But so too are capital expenditures, increasing dividends or making an acquisition. While buybacks usually lift a share price, the effect can only be temporary. In even a few days, the share price can top and stasis or decline sets in. (One study found that following a buyback announcement, executives, on average, sold five times as much stock as they had on an ordinary day.) Notes University of Massachusetts economics professor William Lazonick: “Share buybacks represent value extraction over value creation.”
Who benefits from higher EPS?
Buybacks accomplish several things, supporters say. They reduce the number of shares in the market, thus boosting EPS. (The fewer shares the higher the EPS. Never mind that improved EPS is sometimes one of the reward metrics in executive compensation. Higher EPS can also create the illusion that earnings are improving due to organic growth.)
Buybacks also could demonstrate that insiders think that the stock is undervalued. Insiders may also see buying back shares as preferable to (cheaper than) raising dividends (another use of excess cash), as that cost may be higher than the cost of servicing the company’s debt. If buybacks seem like a good idea on one day, they may not be such a good idea in the long run. Says former presidential candidate Senator Elizabeth Warren: “Buybacks give corporations a sugar high in the short run.”
Are buybacks a misuse of cash?
In the long run, share buybacks destroy value. Anecdotal information says that a stock’s bump after a buyback is announced is often not sustained. In fact, even though a stock might jump on the announcement of a buyback, the air can be let out several days later. (If you’re going to buy, it may be best to buy on the day of the announcement or the day after, and then exit your position quickly).
Critics of buybacks also point out that the EPS boost is artificial, as it is based not on actual news, such as an acquisition, but on the decrease in the number of shares. EPS is boosted because net income is spread over fewer shares. Evidence that buybacks are a misuse of cash can be found in the recently announced $2 trillion US stimulus package, which prohibits a receiving company from using the funds to buy back its shares.
Still, companies that have bought back shares in recent years are not shy about asking for bailout money. The big four US airlines—Delta, United, American, and Southwest—whose stocks are now getting crushed because they may run out of cash in a few months, would be the primary recipients of that $50 billion bailout, after they recklessly incinerated $43.7 billion in cash on share buybacks since 2012 for the sole purpose of enriching the very shareholders that will now be bailed out by taxpayers.
Air Canada, which bought back $350 million worth of its shares last year, is hoping to be included in a federal handout to airlines. As Professor Lazonick notes: “Share buybacks represent value extraction over value creation.”
The good and the bad of buybacks
There are two more reasons share buybacks may do more harm than good. The announcement of a buyback creates a lot of buzz about a company, but the noise may conceal the hard facts that the company’s growth has stalled or that it is under-performing. A good example is Sears, which engaged in buybacks in 2007-8, even though its earnings were falling.
Secondly, critics cry out that if a company has a good amount of cash on hand, it should channel the money into long-term, innovation initiatives or direct it to employees. For example, one recent study found that McDonald’s could pay each of its 1.9 million employees $4,000 more a year instead of buying back shares.
Perhaps there is such a thing as buying back shares responsibly. Just last year Canadian Natural Resources adopted a new capital allocation strategy that requires half of all future cash after capital spending and dividends be spent on buybacks with the rest to be spent to pay down debt.
When is a buyback advisable?
Shareholder theory, which gained traction in the early 1980s and which posited that managers’ interests should be aligned with shareholders’, still has a grip on many companies, witness the flurry of buyouts in the last two years. The current fraught economic environment has some companies re-considering.
For example, in February, Suncor’s board of directors approved a renewal of its share repurchase program of up to $2 billion beginning March 1, 2020. Just three weeks later the company cancelled the buyback. In the end, whether you should buy shares after a company buyback may depend on nothing more than conventional wisdom—caveat emptor. Or you can follow Warren Buffett’s advice that “There is only one combination of facts that makes it advisable for a company to repurchase its shares. First, the company has available funds—cash plus borrowing capacity—beyond the near-term needs of the business and, second, it finds its stock selling in the market below its intrinsic value, conservatively calculated.”
This is an edited version of an article that was originally published for subscribers in the April, 2020, Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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