Over the past couple of years, corporate buybacks in America have been front and centre on the list of discussion topics of investors. On the one side, we have shareholders, investment managers and executives arguing that buybacks are purely just another form of cash being returned to shareholders, not very different to a dividend pay-out. On the other side, we have investors and politicians arguing that buybacks are artificially keeping the stock market afloat and that it is used as a short-term capital allocation strategy purely for their own gain. Lately, it has even become a political tool for politicians to gain popularity points from potential US voters (the more left, so-called social democrats). Their argument is that buybacks should be restricted (or even banned) and that companies should be forced to re-invest back into their companies. When politicians enter the room, logic tends to leave it. In this article, I aim to apply logic to the most pressing issues and statements surrounding buybacks.
Before we start looking at the data, let’s get a basic understanding of where buybacks originate from. Businesses have a limited set of options when it comes to redeploying cash that is generated. If a company can invest cash back into the company (investing in future organic growth, acquisitions, other liquid investments etc.) and achieve a return above a specified hurdle rate, then automatically that becomes option number 1. If the hurdle rate can’t be achieved, then the options become somewhat limited to either i) paying out a dividend or ii) buying back their own shares via stock buybacks. Keep in mind that we assume that the cash we’re talking about is the residual cash i.e. the cash left over after accounting for operational cash liquidity.
Now that we’ve got that out of the way, let’s look at some of the discussion topics arguing for and against buybacks.
1. Buybacks are nothing more than a form of cash return to shareholders
Economically, there is no difference between paying out a cash dividend or repurchasing shares, as the shares are repurchased with the company’s very own cash on the balance sheet. ROE (return on equity) is based on the accounting book value of a share and EPS (earnings per share) on the market value. Fewer shares in issue after a share buyback with earnings remaining the same would increase ROE and EPS. It is important to remember, however, that this is an artificial increase and not as a result of increased productivity or earnings. This however, is the same for dividends – cash is physically leaving the company and never coming back.
The balance sheet will also be affected through leverage changes (financial leverage = debt/equity). This should however not be an issue and shareholders and analysts need to adjust their models in order to account for these changes.
Before the year 2000, dividends were the predominant form of cash return to shareholders. This trend has accelerated during the years and US companies have started to return more and more cash to shareholders in the form of buybacks.
2. Companies are using all their cash to buy back stock instead of using it to reinvest
The shift (mentioned above) has had some tremendous consequences on two widely used measures namely i) the dividend yield and ii) the dividend payout ratio.
Dividend yield = Dividends/Market Capitalisation
Dividend payout ratio = Dividends/Net Income
Realistically, these measures must be adjusted to take into effect the larger contribution that buybacks have on the cash return.
Cash yield = (Dividends+Buybacks)/Market Capitilisation
Cash payout ratio = (Dividends+Buybacks)/Net Income
This brings us to the following table, which summarises the dividend and buyback percentages in the form of a cash yield and a cash payout ratio for the S&P500.
The table shows that although buybacks have increased, the total cash yield has remained relatively stable over the past 20 odd years. Investors keep beating the drum and pointing towards low dividend yields as an indicator that the markets are overvalued. I urge investors to investigate further and to look at the combined cash yields before they start making generalisations.
The cash payout ratio seems to be quite high though. For 2018 the average payout was 92.12%, implying that 92.12% of the net income was returned to shareholders in the form of cash. This plays squarely into the hands of the negative narrative that money isn’t being reinvested back into business, but rather exclusively redistributed to shareholders.
So, is the above true or is there more to it? Let’s look at the accounting treatment of manufacturing companies vs technology and healthcare companies. It’s essentially the old vs the new and this is especially relevant as the new is starting to make up the preponderance of the S&P500 (technology and healthcare are currently number 1 and 2 in percentage market cap contribution). Accounting policies do a reasonable job in accounting for capital investments of manufacturing companies by capitalising it on the balance sheet as assets that will be written off through depreciation over a long-term period. The effect on the yearly income statement is that the net income is affected by a relatively small expense. Technology and healthcare companies on the other hand must expense some of their capital expenditures (R&D and other intangibles), leading to a net income value which is materially depressed and book values which are effectively meaningless. What I am trying to say is that traditional manufacturing companies’ net income is probably overstated when compared to technology and healthcare companies, and that it skews the cash payout ratio to the upside. This in effect means that the cash payout ratio is probably much lower than the 92.12% discussed above and that companies reinvest more than the data suggests.
Even if the effect of the differences in accounting were to be proven relatively small, which I doubt, the question remains – is returning most of the cash generated to shareholders such a bad thing? The entire existence behind a business is to make money and for investors to reap the rewards. The cash being distributed to shareholders will eventually find its way to other indirect deployment of capital through the form of consumption and spending, and in this way, it is up to market economics to decide where that deployment should be, not a group of politicians who unilaterally denounces buybacks in general.
3. Buybacks create flexibility and signals confidence
The most important reason a company would engage in share buybacks rather than paying out a cash dividend is that, unlike dividends, share repurchases are not a long-term commitment. Since paying a cash dividend and repurchasing shares are economically equivalent, a company could declare a small stable dividend and then repurchase shares with the company’s leftover earnings to effectively implement a residual dividend policy – without the negative impact that fluctuating cash dividends may have on the share price.
Companies may also purchase their own stock, thereby signalling to the market that the company views its own stock as a good investment. Signalling is important in the presence of asymmetric information (where corporate insiders have access to better information about the company’s prospects than outside investors). Management can send a signal to investors that the company’s prospects are good and that they believe their stock is undervalued. It must be remembered, however, that different clientele has different needs with regard to income. Some clients may prefer companies with a stable, constant-paying dividend policy if they are withdrawing from their portfolios on a regular basis. Clients seeking current income will therefore prefer to invest in companies of which the dividend policies satisfy these needs.
In today’s modern age of cheap, online platforms, it is however just as easy to sell some shares instead of having to wait to receive a cash dividend. In fact, you can argue that buybacks are more efficient than dividends because of the favourable tax advantage enjoyed by most investors. As opposed to receiving dividends that triggers DWT (dividend withholding tax), you can sell the shares which triggers CGT (capital gains tax). In most countries the CGT rates are lower than the DWT rates. Keep in mind that this argument probably only holds for regular sales and withdrawals as the frequency creates an average selling price that should offset any unfavourable short-term movement in share prices.
4. Buybacks are malicious
There is a plausible case to be made that a sizeable portion of buybacks are related to managerial short-termism. Investors incorrectly assume that all managers make decisions based on long-term objectives, which is at odds with the proven theory that, in order to create sustainable growth and value, a long-term perspective needs to be prevalent. Too often, managers are incentivised to perform over the short-term, with specific KP’s (key performance indicators) targeting the growth of EPS. The easiest way to achieve this is to increase buybacks. Another, more toxic way, is to buy back stock using debt.
A thorough analysis could possibly prove that a certain amount of small companies are in fact focussing on and implementing this very strategy. It is however up to the market to adjust their valuations according to the increased risk they face and essentially to de-rate them by selling their stock down to lower valuation levels. Most of the influential large caps doesn’t seem to have this issue and wouldn’t be allowed to as they are widely followed and constantly analysed – it doesn’t look like the current state of “malicious intent” is a house of cards waiting to bring the stock market down with it.
As everything in life, buybacks have good and bad qualities. If a manager were to be restricted/limited from buying back their own stock, they’re effectively being limited from performing the very role they were employed to perform – in essence, creating an environment where government apparently knows how to invest capital more effectively than the managers themselves. When considering the good and the bad, the buyback effect on the market doesn’t seem so ugly and quite frankly, the data shows that there’s no alarming issue regarding the current state of buybacks.