Cash-rich corporations in America have been making a record volume of share buybacks recently. According to DataTrekResearch, S&P 500 companies have repurchased $646 billion of their own stock from July 2017 to June 2018. Furthermore, some experts estimate the total will surpass $1 trillion for the 2018 calendar year.
In and of themselves, stock buybacks are not necessarily a bad thing. They signal to the market that the corporation believes its stock price to be undervalued, or alternatively that the company is not facing any other higher NPV investment opportunities for its funds.
When a corporation buys back its own stock, the price of the remaining outstanding shares increases based on simple market dynamics. So stockholders are happy. A stock repurchase program is a way to return money to the shareholders. Paying out dividends is another way, yet can carry more burdensome fiscal implications.
In this current climate, however, I confess to feeling a bit of discomfort when I witness stock repurchase programs reaching new all-time highs. My discomfort stems from several reasons.
First, on the aggregate level it is difficult to justify that the stocks of the companies pursuing buyback programs these days are undervalued. We are currently experiencing one of the longest running bull markets in history. Perhaps a stock market correction is not imminent, but few financial experts disagree that, by many measures, valuations across-the-board are floating in the higher end of the hemisphere.
Secondly, some critics contend that the driving factor for many of these stock buyback programs has been not the company’s over-performance in generating excess cash flow, but rather largely due to the U.S. government’s boondoggle of a corporate tax cut. America’s Tax Cuts and Jobs Act was passed in December 2017 and took effect on January 1, 2018. The corporate tax rate was lowered from 35% to 21%, and a one-time amnesty was granted to corporate repatriation of cash from overseas subsidiaries. U.S. corporations are thus flush with cash following this new legislation.
More concretely concerning, though, is the evidence that the current generation of companies engaging in corporate stock buybacks subsequently under-perform the market. This recent study published in Barron’s tracked U.S. companies who repurchased at least 5% of their own stock over the past 12 months. This basket of prolific corporate re-purchasers is under-performing the S&P 500 (see graph).
Finally, making me most uneasy about the magnitude of corporate share buybacks is the temptation for abuse due to misaligned incentives. It is not uncommon for executive compensation packages to include bonuses for stock price performance. For a manager who benefits from such a bonus plan, launching a corporate share buyback program would boost the company’s stock price (again by simple market dynamics) and thus unlock the bonus payments. Ideally, such executive compensation plans would contain paris passu adjustment clauses. I have struggled to identify examples where this is clearly the case. I would welcome a study that examines this issue more rigorously.
And remember, when a company allocates cash toward repurchasing its own shares, those funds cannot be used to invest in other activities which may generate greater long-term shareholder value, such as investing in new innovative projects or even in the company’s human resources.
To all the U.S. corporations currently engaging in stock repurchase programs: I would encourage you to allocate but a miniscule fraction of your ostensibly excess cash reserves to following the admirable lead of Patagonia: grant your entire U.S. workforce a paid day off during the upcoming U.S. electoral voting day on November 6th.
