Are Buybacks Ever Good for Investors?

Today, Mark Hulbert published an article in the The New York Times, titled "Are Buyback Stocks Still Good For Investors?".  Drawing off the fact that so far this year companies who have initiated buyback programs have underperformed the overall market, he investigates the historical outperformance of buyback programs and explores reasons for the recent outperformance.

Before even digging deeper, I contend that even if buybacks are truly better for shareholders over time, looking a little over a year of underperformance, after many years of outperformance, should not be a reason to conclude that they are no longer beneficial.  Companies that issue dividends have outperformed the market for many years, but the fact that they have not during some periods does not disprove that dividends are beneficial for investors - but rather that investors at some periods of times do not prefer dividend paying stocks to non-dividend paying stocks. 

Anyways, companies buyback stock for a variety of reasons, all of which will not be mentioned here.  One main reason is to prevent the dilution of shares due to employee stock options.  Another reason is simply a way to reward shareholders instead of issuing a dividend.  A company who has a lot of cash but no attractive capital budgeting opportunities, and does not want to issue a dividend (which is usually something that is set in stone) can choose to buy back stock to reward shareholders - reducing the float and increasing their earnings per share.  Lastly a company can initiate a buyback program to indicate or restore confidence in their stock, or to concentrate voting power when facing possible takeover.  Buying your own stock indicates a degree of value and optimism about future profitability.

Note, that in the last reason I mentioned "initiate" a buyback program.  Many companies do not have to buyback stock when they announce that they will.  The announcement to the market that they will usually is good for a short term bounce as the market anticipates the move.  In his article, Hulbert writes,

Previous research has found that managers under extreme pressure to bolster their company’s stock price often make aggressive use of discretionary accruals. Their behavior isn’t necessarily illegal. But their accounting legerdemain typically has the desired effect for only brief periods. In the long term, such companies’ stocks tend to lag those of businesses that don’t make heavy use of discretionary accruals.

The professors reasoned that managers under pressure to increase their company’s stock price are likely to use all the tools in their arsenal. So if they were willing to mislead investors by inaugurating a bogus buyback program, it is probable that they will have also used discretionary accruals aggressively. Professor Ikenberry said he and his fellow researchers had found that, at most, only a “small minority” of companies that announced buyback programs from 1980 to 2000 had also made heavy use of discretionary accruals.

Though this doesn’t prove that the bulk of buyback programs were created without an intent to mislead, Professor Ikenberry said it is reasonable to make that inference. He cited another finding of the study to support this view: the stocks of buyback companies tend to perform much better over the long term when they don’t use discretionary accruals aggressively.

This basically states that companies who have bought back stock have done well over time, but those with unscrupulous managers prone to accounting chicanery, have not.  This makes a statement more upon management than anything else.  Obviously we would never be able to see how the companies would have favored if they had not bought back shares, or they had issued a dividend instead.  Additionally, reinvesting money in an increasing asset compounds growth and should outperform a buy and hold strategy over time.  This is why the dividend reinvested return is much greater than the price return of market indexes over time.  This is the fundamental argument for investing in dividend-paying stocks in the first place.  The chart below shows that this principle.

For each reason mentioned above, in neither case is the action of a buyback more beneficial than issuing a dividend.  In the case of the stock options, a buyback indicates nothing about the financial outlook of the company.  It is choice between share dilution, which is bad for investors, and no share dilution, which is neutral.  Plus, the fact that dilutions are smoothed by buybacks negates the whole point of compensating executives with options.  They are supposed to be an incentive to unlock shareholder value.  If earnings are being diluted at a rate faster than management expects them to grow, then ladies and gentleman, we have a problem.  Being able take care of dilution via share buybacks is simply a waste of shareholder capital.  Instead of using capital on earnings growth, investing in profitable capital projects it is used to buy up shares of the old capital projects and essentially pay wages.  This cycle can feed on itself as any earnings growth is offset by massive share buybacks, causing what may be a mediocre management team look like stars.  Furthermore, if a CEO knows that any share dilution his options package causes will later be bought back to fix, has much less of an incentive than one who is not.  The benefit that this takes away from shareholders is mainly transparency. 

Another reason to buy back stock is that a company has generated too much cash and the most profitable place to invest the cash is in shares of its own company.  This is a sneaky way of just leveraging their current projects without actually adding it.  Since it reduces the amount of shares outstanding, no earnings growth will increase earnings per share automatically - essentially taking this quarter's earnings and rolling them over to next.  An earnings per share growth of $10 million will have a much larger "per share" increase since there are more shares at time t than there are at time t+1.  Likewise, if earnings fall, earnings will fall much quicker than expected, unless of course more shares are bought back.  The point of using financial leverage is to borrow money against one's balance sheet to finance an investment that can have a return that is greater than the debt to fund it.  Companies who issue buybacks in this manner use this to leverage the earnings from their current capital expenditures.  Instead of going to the debt markets, however they are borrowing from shareholders.  Although this is widespread it is done sometimes by technology companies who have tons of Goodwill on their balance sheet, against which they can not borrow, this is their only way of obtaining leverage.  The problem is, just like a firm that is highly leveraged and burning cash on interest expense, a company who is continually buying back to reap a payoff is taking away from investing in future projects.  The difference, being, that it looks good doing it, while a highly leveraged company looks terrible.  Once again, the problem is transparency. 

The argument you hear from many CEO's when announcing a buyback, "We see is no better investment than our own company" is complete bull and a enormous assault on shareholder's rights. Shareholders elect management to invest their claims to earnings in working capital in capital projects and that is where they invest in their own company.  If they can not find any more opportunities, then they should expect their money back through a dividend.  If they believe the company's prospects are bright they can choose to reinvest in shares of the company, if they do not they won't reinvest or will even sell their shares.  This is management's way of taking shareholder cash and not just telling them what to do with it, but actually doing it.  Shareholders are owners of that cash and management is the users of that cash.  If management themselves say they have no other use for that cash, then the cash should be returned to shareholders to decide.  Dividend reinvestment is actual share buyback, not to mention than cashing out this "expected stock price" at the capital gains rate. 

The fact that a company has nowhere else to invest its cash is the sign of a maturing company - one that  should pay a dividend if it has extra cash.  And, like it or not, our economy has many of them because it is a maturing economy.  By buying back shares, a maturing company is trying to fool shareholders and itself that it is still in the early stages of its growth cycle.  If it were a person it would be the forty year old woman at the bar with tons of makeup, a body way past its prime, and clothes made for a 20 year old - we have all seen her.  All buybacks do is take away a layer of transparency and add more unpredictability.  As the lady at the bar will eventually find out, you continue to add layers of makeup, and buy new clothes, but you can't fight age. 

Comments

[Bill aka NO DooDahs!]

The people who benefit the most from share buybacks are share-SELLERS, because they get the cash of the company directly.

Possibly a key metric to examine would be the intersection of insider selling and share buybacks. Centex was a poster-child for this not too long ago ... the management-approved buyback amounted to a transfer of money from the company and to the insiders whose shares were bought by the company ...

[ZeroBeta]

Bill,

Thanks for the comment.

I agree with you completely that it is a form of transfer. I tried not to be too cynical because for one I have a tendency to do that, but also I didn't want to harp on whether it is right or wrong, or imply too much wrongdoing, because at the end of the day, shareholders seem to not care as long as stock price increases. Therefore, I tried to focus on why this increase is not good regardless of management's intent and is not good for long term investors. I left out the example where management acts in an unscrupulous manner for that very reason.

In fact, I expect that management is acting in its interest and assume that they are lying to me when I buy a stock. Earnings management (or manipulation) is detrimental to long term investors as it creates more information asymmetry and allows those who know the actual deal to be at an advantage and do not allow the most important vote a shareholder has - a sell ticket - to be exercised properly.