Response to Michael R. Levin on Buybacks

Thanks to Michael R. Levin of Valuewalk for his thoughtful, respectful, if unpersuasive attempt to rebut my Huffington Post column titled: Can’t Boards Find a Better Use for Capital Than Buybacks? I genuinely appreciate the opportunity to engage on this topic.

Levin does a good job of setting out the conventional portfolio manager’s view on buybacks.  We differ because my approach is more systemic.

I try not to make too many analogies to the financial meltdown, but I have to point out that it was not that long ago that a worthwhile financial tool was abused in a manner that caused systemic harm. So it can happen. As I explained in my piece, current buybacks are not based on traditional indicators and they can reward executives to the detriment of shareholders.  I believe that calls for a better analysis and explanation from the executives and boards who authorize them.

Levin says I am wrong, and yet he agrees with me more than he thinks.  He writes:

[She] assert[s] “a public company[‘s] … primary obligation by law and presumably by market forces is to find the best use for that money to create long-term value for shareholders.” Nowhere does any law obligate a public company to “create long-term value”. Market forces don’t “presumably” obligate companies to do that, but in fact do so.

My response: The fiduciary obligation of directors and executives is to run the company for the benefit of shareholders. That legal obligation is our attempt to minimize the inherent agency costs in the capitalist system so that people will be willing to entrust corporate officers and directors with their savings.

It is tautological that a corporation that is worth more is a corporation that is worth more, and long-term value creation by definition creates more value than short-term. Even if a company is sold, that price should encompass a present value greater than the expected returns from the company’s current structure. If a company is sold for less than that amount, a shareholder lawsuit for damages is likely to succeed because the fiduciary obligation has not been met.

Levin said in an email on this issue that the fiduciary obligations of “duty” and “loyalty” are about process. But, as legal scholars know, process and substance closely relate and even overlap. One of the clearly defined “process” steps for a board considering a business combination, for example, is retaining an investment banker for an letter about the deal. And what is the term for that letter? A “fairness opinion.” That letter will tell the directors whether the proposed deal meets the standard of creating long-term shareholder value. And that is as substantive as it gets.  It would be interesting to see which buyback programs could pass that test.

The duty of “loyalty” means the interests of the shareholders come first, and shareholders invest because they want value creation over the long term.  As for whether market forces “in fact” obligate companies to create long-term value, it is just that Panglossian view of buybacks that I question with my use of the term “presumably.”

Levin says:

She also has a limited view of how corporations invest. Company leaders “decide whether [investor funds] will be spent more effectively on research and development of new products or on marketing the old ones.” Investment goes way beyond R&D or marketing, and can include human capital (surprised she missed it), production capacity, and many other uses. Better to direct corporations to either invest capital or return surplus funds to shareholders, and then classify the myriad ways to invest.

My response: My reference was not to GAAP reporting; it was to strategy.  Money spent on human capital, production capacity, or for any category has to be in furtherance of  development of new products or marketing old ones to generate long-term growth or it is not a legitimate expense.  Product development and marketing (including operational improvements) encompass and/or exemplify the uses of capital that Levin names and every other appropriate allocation option, too.

Levin says that one of the sources I cite, the IRRCi/Tapestry report on interviews with directors about buybacks, “provides interesting anecdotes, but hardly a rigorous study of the subject.”

My response: No argument there from me or from IRRCi/Tapestry, I’m sure.  I cited the buyback numbers from the introduction to the report, which were quantitative and “rigorous.” As Levin noted, the report is not an analysis of the benefits of buybacks and does not pretend to be.  It acknowledges in its title that it is a report on the self-reported views on buybacks of a small group of directors.  I cited it for the purposes of identifying the inadequacy of the directors’ responses, which, in calling for better disclosure, the report’s conclusion did as well.

If the report  was dispositive, I would have deferred to the respondents’ reassurances of legitimate reasons for buybacks. Indeed, it is the very unpersuasiveness of their justifications that is the basis for my conclusion that there is reason to be concerned and need for more transparency.

A particularly significant finding in the report is the discrepancy between what boards say they do and what they disclose.  I quoted the report:

Although a number of directors mentioned that their companies project how buyback activity will affect EPS and adjust targets accordingly, only 20 S&P 500 companies disclosed that they did so.

If they do so, they should disclose it.

Levin says that “boards should avoid most conventional earnings measures” in setting performance goals for incentive compensation.

My response: I am happy to agree.  I had hoped my reference to Gretchen Morgenson’s use of the term “growth mirage” would have flagged that issue, but I am glad to reiterate my concerns about conventional earnings measures.

As long as earnings are still a popular metric with many executives, investors, and analysts, though, it is worth pointing out that to the extent that they are using earnings as a measure, boards should not game the metrics by failing to adjust targets to reflect the smaller number of shares.  The IRRCi/Tapestry report notes that only “a few” of the directors interviewed said  “that their companies had adjusted compensation downward when targets were hit due to buybacks not expected at the time the targets were set….Many more directors said that their companies could do this if it were ever warranted.”  I’d like to hear more from them about when compensation adjustments would not be warranted, even if the buybacks were expected.

Levin wants to know who it is that wonders whether buybacks are providing the value investors are entitled to expect.

My response: I suggest he take a look at the concerns raised by, for example, CFO MagazineGretchen Morgenson, economics professor William LazonickInvestopediaValue Stock GuideMarketwatchMotley Fool, and The Street.

Levin disagrees with my concerns and the source I cite on the increasing use of debt to finance buybacks.

As evidence, she quotes a bond market analyst, who naturally worries about companies increasing debt and decreasing equity. She also fails to explain how increasing debt leads to short-term gains and long-term risks, or even defines those terms with any rigor.

My response: Most institutional investors are holders of both debt and equity, and I am looking at this issue from a systemic perspective, so take a holistic, market-wide view of these transactions.

It is the buybacks that lead to short-term gains (meaning that the stock price usually goes up) and it is debt that leads to the long-term risk inherent in any borrowing.  If Levin believes that buying with debt does not pose inherent risks compared to buying with cash and that there is no long-term risk in use of either debt or cash to finance transactions that are closer to financial engineering than strategic growth, then  we will have to agree to disagree.

I am not persuaded by the numbers on buybacks in the past. As I explained in my piece, these transactions are different.  The sharp and unprecedented rise in debt-financed buybacks when the market is at all-time highs merits better explanation from corporate executives and directors and greater concern from investors when they do not get it.

Any significant change in corporate finance is worth a closer look. In this case, the spike in buybacks and the unprecedented use of debt to finance them should raise questions like this:

  • How high does the number of participating companies and dollar amount of buybacks have to get before it is an indicator of a problem in the sustainability of our companies and our economy?
  • What are the transaction costs for investors who must find a new place to put the excess capital that has been returned to them?  How much higher will that be in an environment when so many companies seem to have no ideas on how to use capital to create long-term, sustainable growth?
  • Should investors insist on more detailed information about the process and calculus for determining the benefits of buybacks? Why are companies reluctant to provide this?

He questions whether there is a cost/benefit justification for the disclosure I call for, but Levin’s own conclusion is: “everyone could benefit from solid evidence, about this controversial point, and about the subject overall.”

My response: I am glad to see Levin acknowledge the controversy and I hope he will join me in supporting the research and transparency that would make this empirical analysis possible.

from Nell Minow, VEA Vice-Chair

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