Beneficial Buybacks

Editors’ Note: We assess policies solely for their potential market impact. Our political commentary is intentionally non-partisan. Bias blinds in investing, especially political partisanship and ideology, but stocks favor no party or politician.

Stock buyback critics have been getting louder lately, approaching fever pitch last week after one prominent senator wrote an op-ed decrying them in The Wall Street Journal. The anti-buyback crowd then piled on, primarily arguing buybacks starve the economy by somehow depriving it of crucial funds—for workers and investments—that could otherwise boost growth further.^[i] We believe this view is mistaken. Rising buybacks don’t inherently rob the economy of capital and aren’t a sign the economy is fundamentally broken. Rather, in addition to shrinking stock supply and boosting earnings per share (both bullish), they help capital recirculate to where it can be used best.

The anti-buyback arguments seem to rest on the fundamental misperception that money spent on buybacks goes down the drain. However, as we explained last month, this isn’t true. When companies buy back stock, they buy it from individuals or fund managers. It should go without saying that these people receive money in exchange for their shares. Money they can then spend or reinvest elsewhere. It can fund consumer spending—America’s biggest economic driver!—but, more likely, shareholders recycle returned capital and invest in other ventures. Those other ventures can invest in new equipment or research, open new facilities, hire more workers and raise wages—what buyback critics want! America isn’t starved of capital—there is plenty to go around—and stock buybacks help spread it to where it is most useful.

Despite a record $437 billion of stock buybacks in Q2,^[ii] which could reach upwards of $1 trillion this year,^[iii] corporations are investing plenty. Business investment is at record levels, growing 7.3% annualized in Q2 and 11.5% in Q1.^[iv] Corporations can walk and chew gum. That said, large-scale corporate expansions aren’t necessary to drive broad-based economic growth. Take a well-known company that rhymes with Scrapple. Critics contend companies liquidate themselves with large stock buybacks, taking perfectly useful capital out of the business and destroying the chance for future growth. But as one astute analysis notes, Scrapple proves this is “a contradiction in terms—self-liquidating to $1 trillion.” Those who cite eye-popping buyback figures as evidence firms can’t be investing back into the business miss a key point: It doesn’t take sky-high investment to develop new products in this day and age. The aforementioned Scrapple routinely spends just a couple billion per quarter on R&D. Companies can invest a relatively small sum and get a big bang for their buck(s). So weighing buybacks against capex is a false comparison.

Moreover, much of the blowback presumes companies are using working capital alone to fund buybacks. But this isn’t so. Companies aren’t limited to a finite pool of cash on hand. They can borrow to fund buybacks and investment. Leverage is a time-tested way to grow a business. At today’s interest rates, borrowing for buybacks makes financial sense. The S&P 500’s forward price-to-earnings (P/E) ratio is 16.6 presently.^[v] Flip it around (E/P), and its earnings yield is about 6%. This is the average after-tax return for a shareholder in Corporate America writ large if earnings stay constant. But a typical mid-grade (“BBB”) borrower can take out debt at 4.3% now.^[vi] So borrowing to buy back stock would bring in an extra 1.7 percentage points for shareholders—makes sense! Even better, this leaves cash to fund more initiatives.

Efforts to restrict buybacks seem misguided, in our view. Therefore, it probably goes without saying we see the “Accountable Capitalism Act” described in that senator’s op-ed as largely a solution in search of a problem. It would require businesses with more than $1 billion in revenue to obtain a federal charter broadening their remits beyond maximizing shareholders’ value to include other supposed “stakeholders,” like their customers, employees and the wider community they reside in. It would do this by having workers elect 40% of corporate directors, forcing 75% of directors and shareholders to approve corporate political expenditures, and locking up directors’ and officers’ shares for five years upon receiving them (as part of stock-based compensation) or for three years after a stock buyback. Though well-intentioned, we fail to see how it would accomplish much other than adding bureaucratic hoops and paperwork. Wages and salaries are a market function, based on supply of and demand for labor. They are also generally determined by middle management, not at the board or shareholder level, except in the case of executives. Additionally, reducing buybacks could actually clog up capital, preventing it from finding its most productive use, to the entire economy’s detriment. This strikes us as another reason markets should remain thankful for gridlock, which likely keeps this bill from going anywhere.