Stock buybacks divide investors, the media, and politicians. Are they a good thing or not? The answer is simple but the nuances aren’t.
When allocating capital, whether raised or retained through operations, companies have three choices: 1) invest in organic growth, 2) engage in M&A, or 3) return capital to claimholders by paying down debt, paying out dividends, or buying back stock.
Similar to dividends or paying down debt, stock buybacks (or “repurchases”) are a way to return capital to claimholders. While a dividend is a cash bonus to the shareholder, a buyback takes shares out of the market and increases the continued shareholder’s ownership of the company. The shareholders who elect to sell their stake to the company can happily do so, receiving cash for stock, while the remaining shareholders see their ownership percentage go up while the company cash goes down.
Because buybacks are only one of the three capital allocation options, they’re dependent on the opportunities in the other buckets. The bucket to allocate capital to is the one that promises the highest return with the lowest risk.
So between keeping the cash or returning it to claimholders, how do you know whether management allocates capital to the right bucket? One useful way is to think about Buffett’s $1 test:
We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.
Unrestricted earnings should be retained only where there is a reasonable prospect—backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future—that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
By “generally available to investors” Buffett means the opportunity cost of capital. A business only passes the $1 test if it earns a return on its incremental investments over its cost of capital. So if a business is able to deploy its capital and generate an incremental return over its cost of capital, it would avoid using the 3rd option of returning capital to claimholders.
That requires an “unless”. As many strategic actions are based on projections, sometimes stretched far into the future through arcane budgeting methods, they will to some extent always be risky and uncertain. Sometimes, they’re leaps of faith into the unknown.
So there can be a certain capital allocation option: when a company’s stock is selling far below intrinsic value in the market. When that happens, management has an easy capital allocation choice rather than a hard one.
In other words, when good businesses with comfortable financial cushions find their stock trading meaningfully below intrinsic value, no alternative action can benefit shareholders as certainly as buybacks. Buybacks, when done right, are a value investment.
Buffett:
Repurchases [are] sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80 cents or less. […] But never forget: In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value.
The main difference between buybacks and dividends, aside from trading cash in hand for increased ownership, is that dividends force taxes upon the shareholder. In contrast, by returning cash through buybacks, the shareholder can decide whether to sell some shares for the income and pay the contingent capital gains tax.
Buybacks postpone taxes while dividends don’t. All else equal, if a company buys back stock at or slightly above intrinsic value, the value to shareholders should still be higher than paying a dividend. It’s only when the price-to-intrinsic value gap exceeds the downside of forced tax payment that dividends make more sense. Where the specific gap is, of course, depends on the tax jurisdiction, the various tax rates (short and long term) that apply in said jurisdiction, and the holding period from when the buyback occurred (if the existing shareholder goes out and sells the stock right after the buyback, there’s no tax benefit, and some jurisdictions even favor dividend taxation).
Reality is never “all else equal”. Intrinsic value is probabilistic, an intermingled number from a wide range of branches on a decision tree of future possibilities. A dividend is a definite present return that will be taxed whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold. Investors use different hurdle rates and some may dividends even as the price is trading at intrinsic value.
There’s another reason why companies may opt for buybacks as opposed to dividends which relates to expectations. Dividends are sticky. Once a company pays them, it can’t bounce them around and shareholders come to rely on them. The result is a plan that makes sense in one year and in another year doesn’t. A company is under no obligation to complete its stated buyback program.
These rationales have made buybacks widely popular, swamping dividend payouts for the past 17 years:
There’s a feedback effect: because buybacks boost the share price as opposed to dividends which depress it (on the ex-dividend date the share price is expected to drop proportionally to the dividend), many now associate buybacks with the hope of stock price that never goes down. And because investors are, in the name of behavioral finance, risk-averse, many now tacitly place the responsibility of smoothening the price action with company management, even if it isn’t in the shareholders’ interest. It’s a form of Goodhart’s Law at scale: “When a measure becomes a target, it ceases to be a good measure.”
With careless use of buybacks, shareholders aren’t the only ones to get hurt.
Due to their popularity, buybacks have gotten attention from executives, the media, and politicians to a degree where legislators talk about taxing buybacks at the corporate level. US Senator Elizabeth Warren has said, “Buybacks create a sugar high for corporations. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that.” In 2014, Harvard Business Review claimed that buybacks deserved much of the blame for widened inequality since the financial crisis.
These aren’t new claims. For most of the 20th century, buybacks were mostly illegal as they were deemed market manipulation. Until 1982, a company could only buy back stock through tender offers until open market purchases became legal at last. About a decade later, interest rates started coming down and stock option compensation turned tax deductible, laying the groundwork for massive buyback popularity. In the early 2000s when interest rates were lowered to almost zero, buybacks got tightly correlated with corporate debt issuance.
From a macro perspective, the way buybacks are used collectively can be dangerous for the economy because they urge financial risk-taking. Again seen in the chart above, buybacks, which are more volatile than dividends, have dominated shareholder distributions in heated markets as companies have bought back stock at high prices. In 2019, JPMorgan built a time series showing that the % of buybacks funded by debt has been far higher near market tops than bottoms.
As history shows, companies in aggregate tend to not invest in their stock as a value investor would. They buy high and, if they sell at all, sell low. Why is that?
Intrinsic value is an abstract subject. What looks cheap to one investor may look expensive to another (although there is only one truth). When something is abstract like buybacks, it’s prone to manipulation and incentives.
That’s why buybacks are sensitive to corporate incentive programs. If a stock option program is too excessive or a compensation system too dependent on per-share measures, management may not have the shareholder’s or Buffett’s $1 test in mind when buying back stock. In Reuters’ words, “Stock buybacks enrich the bosses even when business sags.” A cosmetically increasing EPS may be the final push for a big stock option payday, even if it brings no value to the existing shareholders or lower-rank employees. Value creation turns to value extraction. Buybacks turn into a red herring.
One red flag is when you see the company buying back lots of stock but the share count doesn’t go down year to year. When a mass of granted employee stock options is exercised by employees, a company would need to either buy back stock or issue them. And to avoid diluting EPS, it opts for the former. There’s no logical rationale for doing buybacks to offset dilution from the exercise of employee stock options at any price. But companies do it anyway.
The good news is if you can effectively assess the company’s value, it should be easy for you to judge the competency of management by looking at how it acts around the share price. You also need to look at its incentive program and opt for one that doesn’t reward short-term earnings targets and which requires executives to hold stock with a lockup. One that rewards long-term behavior.
Whether a buyback is good or bad depends on each company’s circumstances, opportunities, and incentive systems, and investors shouldn’t judge a stock based solely on the company’s buyback program. In any case, buying back stock at a meaningful discount to intrinsic value is almost always a sensible thing to do. If you invest in a company that keeps buying back its stock, you better hope for the price to stay low.