I noted last week that, in the US, big companies have long been the only net buyers of equities. It is also worth pointing out that 25% of S&P 500 companies now do not pay a dividend. They prefer using their cash to buy their own shares.
In the early 1990s, some 25% of corporate cash flow was distributed as dividends. That number is now 17%. Today, share buybacks account for 25% of cash flow.
But why this new mania for buybacks? The general idea is that company managers figure out when their shares are cheap, and buy them in below their intrinsic value. That creates value for the remaining shareholders: they’ve effectively bought a cheap asset, and there are fewer of them to share in the proceeds of future growth.
There are tax advantages too: most countries tax capital gains less than dividend income – so it makes sense to encourage policies that produce the former.
All of this sounds entirely reasonable. And if the story ended there, it would be. But it doesn’t.
Take the business of price. How is a chief executive to know when a stock is cheap? The best brains in the world go into finance, but we know that the combined opinion of those brains on what constitutes value is of no use whatsoever. Check your pension performance if you are in any doubt on this.
We also know that you can’t create value if you buy stocks at too high a price. All that does is give the shares a little longer to bubble before they fall, vaporising shareholder value as they go.
Sadly, history offers clear proof that executives are as useless at equity valuations as analysts. As Andrew Lapthorne of Société Générale points out, companies usually buy back shares when they have lots of cash. That’s also usually when share prices are high. I give you Citibank and the near-$15bn it spent on buybacks in 2006 and 2007.
But that’s not the only reason to be wary of buybacks.
Next is the fact that companies are supposed to spend on productive activity: raising profits for future shareholders; raising the present value of the shares for current shareholders; and raising general economic activity along the way. Pour all the money into buybacks, and that doesn’t happen.
Then there is the fact that the stock market – everywhere – is supposed to be a long-term compounding machine. Replace dividends with buybacks, and – as Lapthorne puts it – you make equities into a “speculative trading vehicle” instead.
So why do executives do it? You might not be surprised to find that they make money out of it.
How? Two ways. If you buy back shares, earnings per share (EPS) automatically rise. So, if your bonus is linked to EPS, you are instantly quids in. It’s the same with share options: dividends push their value down (shares tend to fall back after they are paid); but, if you buyback and bump the share price up, your options are suddenly worth more. And if you keep issuing options and arranging buybacks, the percentage of stock held by employees – and their wealth – keeps going up. Simple really.
Not convinced? Ask then, as Lapthorne does, why “is the buyback never executed at the time of option issuance?” Quite.
Add it all up, say the analysts at Bedlam Asset Management, and you will find that buybacks tend to have a variety of trying consequences.
They destroy shareholder funds; they offer a disproportionate benefit to employees via share options (unless options are adjusted to take account of them); they represent “the gradual expropriation of shareholder assets” and the regular misallocation of capital; and finally, like almost everything else, they enrich the investment banks (dividends bring advisers nothing, buybacks bring them oodles of fees).
And people wonder why buybacks used to be illegal!
But, for me, there is an even more important point: it shouldn’t be the job of listed company managers to occupy their time with financial engineering, nor should it be their job to figure out when shares are cheap or expensive. It should be their job to run the shareholders’ company to the best of their ability, and to assume the share price will follow performance over the medium and long term – as it always does.
This takes us to the scandal of performance-related pay. As long as a manager’s route to ridiculous riches is predicated on his ability to use every shenanigan in the book to keep his share price up, that it what he will do.
This is symptomatic of the mess we have made of modern capitalism. We’ve created a system where we allow, encourage even, chief executives to waste their time manipulating share prices rather than creating and paying out a tangible income to shareholders. So while I am thrilled by the idea that investors are finally finding a voice with which to protest against the institutionalised theft of their returns via high executive pay, I hope that they remember that buybacks are often part of the mechanism of that theft – and vote against them too.