Share buybacks are all the rage at the moment, thanks to a bullish US market and generous corporate tax breaks. The good news is that many equity income managers swear by the good old share buyback. Their argument is that if a mature listed business can’t find a sensible, productive use of spare capital, then it should let the investors do the decision making. Hand the capital via share buybacks and then investors can make their own mind up about what they want to invest in. This mantra of corporate capital efficiency has been extensively embraced by CEOs and boards in the US and share buybacks are now all the rage.
There’s even ETFs which deliberately target listed businesses who’s share base is shrinking. AdvisorShares, for instance, has Wilshire Buyback ETF (NYSE Arca: TTFS) which is based on the belief that “the prices of stocks are influenced by supply and demand, and that stocks should perform best when their outstanding shares decrease. All else being equal, if the same amount of money is chasing a smaller number of shares, then the share price increases”. Crucially this screening process rules out firms that take on too much leverage as a result.
But I think it’s also fair to point out that there’s a growing army of critics of the share buy back model. These come in two varieties – a more overtly political camp of economists who think it’s a disaster for the US economy as against a more technical camp of strategists who think it distorts the market and encourages leverage. In the former camp you’ll find academics such as William Lazonick, who amongst other things writes excellent pieces for the Institute for New Economic Thinking. He thinks that share buybacks ‘hurt workers and the economy’ and that the US government ‘should ban them’. You can read his strongest polemic online at Ineteconomics here.
Lazonick alleges that share buybacks have become insanely popular for three reasons. “ First, the stock-based compensation of senior executives incentivizes them to do distributions to shareholders…Second, for more than three decades, executives of major U.S. corporations have preached, conveniently masking their self-interest, that the paramount responsibility of their companies is to “create value” for shareholders….Third, in recent years hedge fund activists have ramped up the pressure on companies to do buybacks.”
The result, Lazonick claims, is that US corporates are deprived of capital for long term investment. “Repurchases done on the open market, which constitute the vast majority of all buybacks, are nothing but manipulation of the stock market…..buybacks wreak immense damage on households, companies, and the economy. The profits that major corporations reinvest in productive capabilities form the foundation for a prosperous middle class. Buybacks deprive companies of that investment capital, instead serving as a prime mode of making the richest households richer while eroding middle-class employment opportunities.”
Many stockmarket strategists are also critical of share buy backs, not least Andrew Lapthorne over at SocGen who monitors net buybacks from the US report and accounts cashflow statements. His analysis suggests that these US buybacks have risen a substantial 30% YoY following the US tax changes, with the current quarterly run rate at around $190bn gross, or a net $160bn if you measure the actual reduction in shares. “This is down from the $200bn+ in Q1, but we are now seeing estimates of $1trn+ in announced buybacks to come, which if executed would require a 50% quarterly step-up in US buybacks – an extra $100bn per quarter.”
Crucially he argues that a large chunk of this buyback capital is “is being funded by cash from the balance sheet and the selling of liquid investment. Net Debt is therefore on the rise. The US shareholder yield is running at around 3% on an ex-financial basis, but this compares to a European dividend yield of 3.6%. So not all that impressive. And of course, every quarter that cash pile is getting smaller.”
Intriguingly Lapthorne also argues that a more sensible strategy is to announce a buyback and not actually carry through the purchases – which is empirically “the best course of action for a company”.
My own take is slightly idiosyncratic. On the one hand, economists who criticise excessive share buybacks and high dividend payouts seem blind to the fact that many of the beneficiaries of these capital flows are huge pension funds underwriting the retirement income of hundreds of millions of Western workers. These clients are desperate for an income in a monetary environment experimenting with decades-long financial repression. If you’re looking for anyone to blame, look at the central bankers for generating a wall of demand for yield.
But I also worry that as the wall of passive money grows to a huge scale, the technical aspects of buybacks become more important. On the one side we have a huge inflow of investor cash, much of it from passive funds and on the other hand, we have a shrinking supply of quality, mature corporate cashflows as expressed by buybacks. As buybacks intensify this passive money is forced to reinvest in the shrinking pool of quality business paper, pushing up valuations. The problem here is that this passive money is rules bound i.e it needs to keep investing according to its asset allocation principles. This means that allocators of capital become in essence ‘dumb’. They’re not going – “gee I have all this extra cash, let’s find a more productive way of investing capital in newer ideas”. Instead, they simply go back to their allocation guidelines and keep reinvesting in the same narrow pool of large cap securities – chasing the shrinking pool of shares. We thus end up with a new version of the Nifty Fifty, powered by passive flows and engineered through excessive debt levels i.e a potential recipe for disaster.