Are Stock Buybacks Really A Big Problem?

I read a recent article in the Wall Street Journal entitled The Real Problem with Stock Buybacks (WSJ paywall)  which spent a lot of time discussing multiple pitfalls of stock buybacks and touched on some lawmakers in Washington who would like to limit, or completely outlaw, the practice. To say I was dumbstruck by the piece would almost be an understatement.

Let me go through some of the article’s points.

First, the idea that the SEC should have the ability to limit corporate buybacks, if in its judgment, carrying them out would hurt workers or is not in the long-term best interest of the company.

To be fair, the authors disagreed with this idea. They were simply bringing to readers’ attention that it was out there. Public companies are owned by shareholders, and those shareholders are represented by the board of directors (whom they vote for). The CEO serves the board on behalf of those shareholders, though admittedly this is a problem when the CEO is also Chairman. As such, the government really has no place to tell boards how to allocate profits from the business that belong to the shareholders. This should be obvious, but evidently it is not to some. The entire activist investor concept is based on the idea that too few times investors pressure boards to act more strongly on their behalf. The system works, and should stay as-is.

The authors, however, do make an assertion of their own that I fail to understand. They claim that the real problem with stock buybacks is that they transfer wealth from shareholders to executives. More specifically, they state:

“Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses. Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity. Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity. Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.”

This paragraph makes no sense, and of course, the authors (a couple of Harvard professors unlikely to have much real world financial market experience) offer up zero data or evidence to support their claims.

So let’s address their claims one sentence at a time:

“Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses.”

This statement implies that a shrinking share count and earnings per share growth are bad, or at least suboptimal. Why? The reason executive bonuses are based, in many cases, on earnings per share, is because company boards are working for the shareholders, and those shareholders want to see their stock prices rise over time. Since earnings per share are the single most important factor in establishing market prices for public stock, it is entirely rational to reward executives when they grow earnings.

“Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity.”

Insiders are notorious for owning very little of their own company’s stock. Aside from founder/CEO situations, most CEOs own less than 1% of their company’s stock. In fact, many boards are now requiring executives to own more company stock, in order to align their interests with the other shareholders even more. As such, the idea that executives unload stock at alarming rates, and that such actions form the bulk of their compensation, is not close to the truth in aggregate.

In addition, if the stock price is being supported, in part, by stock buybacks, does that not help all investors equally? Just as insiders can sell shares at these supposed elevated prices, can’t every other shareholder do the same? At that case, how are the executives benefiting more than other shareholders?

“Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity.”

This one makes no sense. Insiders buyback stock when it’s cheap?! Oh no, what a calamity! In reality, company’s have a poor record of buying back stock when it is cheap and often overpay for shares. Every investor in the world would be ecstatic if managers bought back stock only when it was cheap.

And how are buybacks a secret? Boards disclose buyback authorizations in advance and every quarter the company will announce how many shares they bought and at what price. It is true that such data is between 2 and 14 weeks delayed before it is published, but that hardly matters.

Again, the authors imply that increasing the value of stock is bad for investors, unless those investors are company insiders. In those cases they are getting away with something nefarious. In reality, each shareholder benefits from stock buybacks in proportion to their ownership level (i.e. equally).

“Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.”

Huh? Buying back cheap stock reduces investor returns and hurts public shareholders? I can only assume that the authors simply do not understand as well as they should what exactly buybacks accomplish and what good capital allocation looks like. It is a shame that the Wall Street Journal would publish an opinion so clearly misguided.

6 thoughts on “Are Stock Buybacks Really A Big Problem?”

  1. Well I agree with most of your points BUT your statement that eps is the single most important thing is equally unsubstantiated.

    Boosting eps through buybacks doesn’t create value – as in intrinsic value. But I think what you are getting at is on. What matters is boards actually taking a role and designing proper compensation arrangements. We should see more FCF, ROIC and intrinsic measures that produce value over the long term while aligning themselves with longer term investors who actually would stand to benefit from smart capital allocation which could include buying back stock (when and if is trading CHEAPLY)

    Enjoy your blog, we think similarly

  2. I would take issue with the argument that boosting EPS via buybacks is a productive use of capital and i guess as a consequence that your blanket statement that EPS is the most important thing for determining prices. Buybacks are only productive if purchased at a discount to intrinsic value.
    I think what’s lost here and most important is steps to make sure board’s are creating incentive schemes that award managers for prudent capital management of which buy backs (NOT growth in EPS) are a component – such measures as ROIC and FCF align much more strongly and subject to less chicanery.

    Above all – great blog – enjoy reading

    1. So I think it all depends on the price paid with buybacks, but the authors seemingly conclude that buybacks done when the stock is cheap cannot be accretive to intrinsic value per share. Sure, it is a gamble on management’s capital allocation skills, but I am not sure spending free cash on growth capex assures a better ROI than buybacks, on average. Heck, a dividend could be worse for investors than a buyback if they reinvest it poorly.

      1. Well that all depends on management using FCF wisely – of course buying back stock when you are well below intrinsic value and reinvestment opportunities are nil makes sense.

        I think EPS growth is a terrible compensation metric and leading mgmt teams get this and align compensation agreements such that the company GROWS value over time at a rate well above WACC

  3. Pehaps this is nitpicking but I disagree with you on the first point. Say normal eps are coming at 87 cents and the executives need 89 cents to trigger extra compensation and use buybacks to get there. Maybe it is not theft but definitely transfer of wealth from shareholders to executives.

    1. I guess my rebuttal to that would be that there is no way of knowing in real time what the shareholder return on that buyback will be. As such, how do we know that shareholders will not benefit from the buyback more than the executives ultimately did?

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