Busting Buyback Myths

Corporate America announced a record $437 billion in buybacks in Q2—close to double the prior record ($242 billion) set way back in … Q1.^[i] This inspired a media smorgasbord of buyback-related misperceptions—some time-honored, some new. We have gathered a few here for exploration and debunking to illustrate a central point: Buybacks aren’t the economic or market scourge folks frequently make them out to be. Allow us to begin with the first common misunderstanding:

1. Trade war fears are leading companies to delay or cancel capital expenditure plans and spend the money on buybacks instead, robbing the economy of crucial business investment.

Setting aside the fact the present tariff back-and-forth looks a lot more like a tiff than a war, we believe linking buybacks to said tiff is speculative. Companies’ actual share repurchase rationales aren’t knowable, and even if you knew their motivation, it might not matter much. The reason: Buybacks can rise together with business investment—and have done so for much of this expansion. In Q2—this period of oh-so-many buybacks—US firms’ capex rose 18.8% y/y.^[ii] Amid the Q1 buyback spree, capex grew 23.5% y/y.^[iii] Looking further back, a March 2018 Harvard Business Review study found S&P 500 companies’ R&D investment and capital expenditures are near their highest (as a percentage of revenue) since the late 1990s. All this repurchasing hasn’t depleted corporate cash buffers, though—these are also near record highs.^[iv] As a result, companies broadly have the wherewithal to both continue buying back stock and investing.

Further, companies’ investment funding doesn’t come solely from new earnings or cash on hand. Companies can borrow for buybacks and long-term investments alike. AA-rated US corporate borrowers can borrow for 7 – 10 years at 3.6% presently.^[v] Meanwhile, the S&P 500’s forward 12-month price-to-earnings ratio (P/E) is 16.5.^[vi] If you flip that—divide earnings by prices—the E/P (or earnings yield) is 6.0%, nicely higher. Given this backdrop, borrowing money to fund buybacks looks like simple arbitrage.

2. More capex and R&D is always a good idea, whereas buybacks sacrifice long-term growth for a stock price sugar rush.

While often profitable, more business investment isn’t automatically the best use of spare cash. The future is uncertain, and spending tons of money preparing for what you think it might hold is risky. Maybe the risk is worth it and the move pays off! But maybe not. Companies facing this decision may occasionally (and wisely) decide it is more responsible to return some of shareholders’ investment.

Plus, if 2008 taught firms anything, it was the value of having large cash buffers in case short-term liquidity dries up. Churning money into ever bolder projects and aggressive expansions risks overreach and bloat—not great.

Buybacks aren’t an economic dead end. Shareholders can redirect the cash to more productive ends—an indispensable feature of a modern, dynamic economy. The Harvard Business Review’s study found a large portion of proceeds from S&P 500 company buybacks ends up funding other (including non-S&P 500) companies, venture capital, private equity, new IPOs and the like. If shareholders want to use the cash to buy themselves all banjos, that is just fine, too. After all, consumption is a legitimate economic purpose.^[vii] And the resulting banjo boom would be epic for banjo builders and bluegrass fans alike.

3. As for the notion buybacks are propping up the stock market—staving off a plunge—this is overstated.

True, buybacks shrink stock supply—generally a positive for prices. But in the very short term, stocks rise and fall irrespective of buyback quantity. One company’s purchases are usually too small to matter. Moreover, stock markets are basically auctions, with each share going to the highest bidder. More buyers don’t mean higher prices—buyers’ and sellers’ relative eagerness matters most.

One more thing: If buybacks propped up stock values, firms doing more of them would lead. But this isn’t always so. Thus far this year, per the Wall Street Journal, a majority of companies buying back shares have underperformed the S&P 500.^[viii] Which brings us to …

4. Companies are buying back their shares at high valuations and losing money when prices drop.

Myopia alert! Maybe stocks of companies buying back shares surge the rest of the year, who knows—as we’ve written, valuations don’t predict stocks’ direction. As for the core argument: Sure, execs would like to buy low—but this is a bizarre metric with which to judge a buyback’s success. As we noted, many factors push stock prices up or down—buybacks cannot outweigh the market, especially since an efficient market swiftly discounts buybacks (which are publicly announced). A better metric: simple profit and loss. With earnings yields higher than bond yields today, most buybacks probably lift earnings.

But buybacks have another, arguably more important goal—returning money to shareholders. Secondarily, they can offset companies’ stock-based compensation, preventing dilution. Both benefit shareholders, whether or not the stock’s price rises in the near term.

5. Companies are spending cash on buybacks instead of hiking flat wages.

Even if true, this is sociology—beyond markets’ purview. And the Atlanta Fed’s wage growth tracker shows wages are rising at a fairly steady, above-inflation clip when you track the same employees over time rather than workforce-wide averages.

Finally, the alleged choice between buybacks and labor spending—whether on wages or hiring—is a false one. Profitable companies can do both.^[ix] And as with any other good or service, the price of labor moves with supply and demand. If companies believe raising wages will boost the bottom line, they will do so. If not, they won’t. Buybacks and cash reserves don’t enter into the equation. Here, as elsewhere, we don’t believe popular handwringing over buybacks squares with the facts.

[i] “US Companies’ Share Buyback Plans Smash Record,” Andrew Edgecliffe-Johnson, Financial Times, “US companies’ share buyback plans smash record,” 7/10/2018.

[ii] “Trade War May Steer Tax Cuts' Windfall to Even More Buybacks,” David Randall, Reuters, 7/12/2018.

[iii] “Investment Boom From Trump’s Tax Cut Has Yet to Appear,” Matt Phillips and Jim Tankersley, New York Times, 4/30/2018.

[iv] Source: Federal Reserve, as of 7/20/2018. Total liquid assets for all nonfinancial corporate businesses through Q1 2018.

[v] Source: FactSet, as of 7/20/2018. ICE BofA Merrill Lynch US Corporate AA 7 – 10 Year Index yield on 7/19/2018.

[vi] Source: FactSet, as of 7/20/2018. S&P 500 Forward 12-Month P/E on 7/19/2018.

[vii] Or as one Adam Smith once observed, “Consumption is the sole end and purpose of all production.” And, you know, we doubt you would appreciate it if whenever you sold some stock, media harangued you to reinvest the proceeds in something else.

[viii] This doesn’t mean buybacks are some sort of contrarian indicator of a stock’s short-term performance—it just shows they don’t predictably push up the price.

[ix] One more time, Harvard Business Review: Since S&P 500 companies tend to have extra cash on hand, “it’s doubtful the downsizing is driven by lack of cash. A more likely culprit is changing business conditions. In our dynamic market economy, firms frequently expand and contract, with employees and assets moving from shrinking enterprises to growing ones. Indeed, if a firm is seen distributing cash to shareholders and laying off workers, the most plausible explanation is that it cannot efficiently utilize either all its cash or all its employees, not that the payout itself is causing the layoff.”