[Senator Marco] Rubio expressed his reservations [about the Tax Legislation] in an interview with southwest Florida’s News-Press Thursday, noting he thinks Republicans probably gave corporations too much of a handout.“<P><P>If I were king for a day, this tax bill would have looked different,” he said. “I thought we probably went too far on [helping] corporations.”The senator believes the bill ― which is projected to add $1.4 trillion to the deficit over the next decade unless it can offset those losses via economic growth ― probably won’t result in multinational corporations investing their sudden windfall in hiring and expanding.Instead, it’s more likely to line the pockets of their shareholders.“<P><P><P>By and large, you’re going to see a lot of these multinationals buy back shares to drive up the price,” Rubio predicted. “Some of them will be forced, because they’re sitting on historic levels of cash, to pay out dividends to shareholders. “That isn’t going to create dramatic economic growth.”
David Trainer echoes our concerns about buybacks and makes a good point — with specific examples — about the misaligned incentives that lead to what he calls “bad buybacks.”
In theory, share buybacks are an efficient mechanism for companies to return cash to shareholders when they believe the stock is undervalued and have more cash than profitable investment opportunities.In practice, companies often buyback shares when their stock is at the highest point, and they sometimes pass up profitable investments or even go into debt to do the buybacks. The timing of buybacks can also be influenced more by when executives exercise their stock options than fundamental opportunity.The issue comes primarily from the poor executive compensation practices in place throughout most of corporate America. Executives are consistently incentivized to hit targets related to non-GAAP EPS and other metrics that are easily manipulated and have little connection to long-term shareholder value.
VEA Vice Chair Nell Minow is quoted in a Bloomberg story about the disconnect between the stock market and the economy.
This isn’t a case of “what’s good for General Motors is good for the U.S.,” said Minow, who’s dedicated her career to pushing corporations toward long-term investments in people and businesses. “In my list of the top 100 things companies should do for sustainable wealth creation, buybacks would be number 100.”
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.”
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 Magazine, Gretchen Morgenson, economics professor William Lazonick, Investopedia, Value Stock Guide, Marketwatch, Motley 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
Just like the rest of us, corporate executives and board members have some tough choices to make about how to spend the company’s money. Or, I should say, our money.
A public company sells stock to outside investors, meaning those of us with pensions and 401(k) plans and mutual funds. Its 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. Of course, they cannot create that value over the long term without attending to the needs of customers and employees and being careful about obeying the law. With that in mind, the executives and directors design the strategy. They have to decide whether the money will be spent more effectively on research and development of new products or on marketing the old ones.
Recently too many companies have opted for a third option — buying back their own stock. A report issued this week from the Investor Responsibility Research Center Institute and Tapestry Networks found:
S&P 500 companies acquired $166.3 billion of their own shares in the first quarter of 2016, more than in any other quarter since the financial crisis….In each of the last nine quarters, at least 370 S&P 500 companies repurchased shares, and over the last three years, S&P 500 companies spent over $1.5 trillion on buybacks. Between 2003 and 2013, S&P 500 companies doubled their spending on share repurchases and dividends while cutting their spending on investments in new plants and equipment. According to data from McKinsey, buybacks have accounted for 47% of US companies’ income since 2011, up from 23% in the early 1990s and less than 10% in the early 1980s.
There are valid reasons for companies to buy their stock, especially when they have excess cash and the stock price is substantially below their internal valuation. If the executives do not have a better use for the money, they should return it to shareholders and let them invest somewhere else. But stock prices are high right now. In buying back their own stock, CEOs are telling us that they can think of no better place to spend the company’s profits than buying their own shares while prices are at record highs. Gretchen Morgenson of the New York Times calls the positive impact on the stock price a “growth mirage.”
The increase in buybacks is a warning sign for three reasons. First, it should be a concern that executives do not have any better operational or strategic ideas for creating sustainable, organic growth. We’d rather have them return capital to investors than to overspend on acquisitions. But we invest in these companies because we believe in their business plans and if they cannot find a use for the capital, they owe us an explanation that has to go beyond financial engineering tied to quarterly numbers.
The second concern is that buybacks suggest that boards of directors have approved incentive compensation plans that promote buybacks even when they are not in the interest of shareholders. If they set performance goals in terms of earnings per share, there are two ways to hit the number: higher earnings or reduced number of shares. Boards should make it clear that they reward only higher earnings. The IRRCi/Tapestry report found “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.”
While compensation consultant Ira Kay acknowledges that executives with more stock options implement more buybacks, he insists that it did not diminish the returns to shareholders over the four-year period he studied. Over the longer term, however, the effects may not be as benign, as the money used for buybacks is not being used for improving operations.
Between 2003 and 2013, S&P 500 companies doubled their spending on share repurchases and dividends. But, at the same time, companies cut spending on investments in new plants and equipment.
A third warning sign is the shift in where the money for these buybacks is coming from. Increasingly, it is not excess cash but debt. David Ader writes in Barron’s:
The bond market should be concerned about stock buybacks, but not because of their bullish effect on share prices. Instead, bondholders should be anxious about where the cash to pay for them comes from. It isn’t widely appreciated that the money has been borrowed in the credit markets, and that the borrowers have taken on a large amount of debt to support the buybacks.
It is one thing to return excess cash to shareholders if executives have no strategic ideas, though it raises questions about management’s judgment and the company’s future prospects. But it is harder to understand a decision to take on debt to purchase the company’s own shares, a maneuver with short-term gains but significant long-term risks.
Directors interviewed for the IRRCi/Tapestry report justified using debt to buy back stock because US tax policies and low interest rates have made cheap and easy to borrow money.
The large build-up of capital in non-US affiliates means that companies have an emergency fund to draw upon should it become necessary. As a result, creditors offer very attractive loans to companies, meaning some corporations are able to engage in almost costless borrowing to fund buyback programs.
The directors IRRCi/Tapestry interviewed insisted that “their companies can afford both buybacks and adequate investment. They listed the usual justifications for buybacks,
• To return capital to shareholders
• To invest in the company’s shares
• To offset dilution from using equity as currency
• To alter the company’s capital structure
Many directors said that they would be unlikely to find enough good opportunities to invest all their companies’ available capital in today’s low-growth, low-interest-rate environment, and that it was often better to return capital to shareholders than to hoard capital or invest in projects with less-than-desired projected returns. Directors also said they tend to prefer buybacks to dividends because they believe a buyback program offers greater flexibility over time.
IRRCi executive director Jon Lukomnik says, “A trillion and a half dollars in buybacks over three years certainly returns capital to shareowners and reduces the number of shares outstanding. That’s why buybacks are popular. But, some view buybacks as financial engineering to juice short-term corporate performance at the expense of investments that would better grow companies and the economy over the long-term.”
The report’s most significant recommendation is for improved disclosures about share repurchase programs, noting, “Few companies publicly disclose details about buyback decision-making and very few state the reasons for a specific buyback program.” Concerns about misaligned incentives and the increased use of debt shift the burden of proof to require much more specific disclosure about the process and calculus used to quantify the benefits of buybacks. Shareholders need to know whether they are getting their money’s worth from buybacks and from the executives and directors who approve them.
Gretchen Morgenson writes about the skewed incentives for stock buybacks:
Some critics say that top managers who preside over big stock repurchases are failing at one of their most basic tasks: allocating capital so their businesses grow.Even worse, buybacks can be a way for executives to make a company’s earnings per share look better because the purchases reduce the amount of stock it has outstanding. And when per-share earnings are a sizable component of executive pay, the motivation to do buybacks only increases.
She cites the approach of Robert L. Colby:
“The simplest way to evaluate a company’s asset allocation decisions over the years is to see whether its net profit growth is close to its earnings-per-share growth,” Mr. Colby said. “Unlike an investment in the business, share buybacks have no effect on net profit and there is no compounding in future years.”
No other topic splits opinions in the financial community like share buybacks.
The pro buyback camp believes that using buybacks to return excess cash, is a prudent way of improving shareholder returns while those against buybacks claim that they are a waste of money and only benefit managers by boosting executive compensation.
Each argument has its valid points; some buybacks are clearly a waste of shareholder funds, but the well-executed buyback can create a lot of wealth for shareholders.
Pay Governance’s study shows a clear correlation between the size of buybacks and the granting of stock options as well as the use of EPS as an annual incentive metric. This might not be a bad thing for shareholders as stock option granting also appears to be correlated with higher shareholder returns:
Ira Kay believes that these figures show that options can be an effective way to motivate executives to create shareholder value, “Companies which grant stock options to their CEOs bought back more shares than companies that did not grant stock options. Importantly, those companies had higher TSR than the companies not granting stock options.” Ira continued, “This suggests that stock options can be an important means to motive executives to create shareholder value, often through the use of share buybacks.”
Low interest rates and a play-it-safe mentality among executives have fueled a stock buyback boom that is slowing economic growth, storied contrarian investor Jeremy Grantham said on Wednesday.
Grantham, well-known for his dour views about the U.S. Federal Reserve’s economic growth efforts and his concerns about the environment, said corporate leaders find it too easy to spend money buying back their stock instead of investing in uncertain capital projects like new factories.
“For a senior management person to use the cash flow of the corporation to buy stock back is much less dangerous than building a new plant,” Grantham said, speaking to an audience of thousands at the Morningstar Investment Conference.
That reduced capital spending is a drag on economic growth, even as labor markets remain slack, the co-founder and chief investment strategist for Boston-based GMO LLC, said.