Are stock buybacks a kind of scapegoat?

Are buybacks a bad thing? As with many questions, the answer is: it de­pends.

The New Republic published an arti­cle in August titled Apple's Stock Market Scam, a stinging piece of writing whose central premise was the following: Apple Inc. did not reach its trillion-dollar valuation by product innovation or by simply be­ing an extremely profitable business. It claimed instead that it had done so by repurchasing billions of dollars of its own stock.

The author wasn't alone in his views. Financial and political pun­dits alike have often painted stock buybacks as a greed-driven tool in recent years, one that detracts from corporate capital investment and thus, from economic growth.

These same pundits often see no issue with dividends being paid to shareholders while not hesitating to malign buybacks. Another com­mon refrain is that buyback policies inflate executive compensation.

Do the data and economics bear these arguments out?

It's true that in developed mar­kets, capital investment as a percent­age of operating cash flow has been on the decline. A few non-buyback issues are to thank for this.

First, the relative size of the tech­nology and healthcare sectors globally has increased substantially compared to other sectors. Compan­ies in these sectors generally have low capital intensity and instead in­vest in research and development.

Research and development often do not factor into reported capital expenditure figures, especially under U.S. accounting rules, and the U.S. represents greater than 60 per cent of developed markets world­wide.

The claim that buybacks are on the rise is provably true as well. Again, however, there is nuance needed in the discussion.

Dimensional Fund Advisors, a ma­jor global investment firm, analyzed buyback and dividend payment ten­dencies of publicly traded American companies from 1973 to 2015.

They did find a steady increase in share repurchases as a percentage of market capitalization.

However, the ratio of total cash paid to shareholders stayed com­pletely flat over the analysis period.

Why? Increases in repurchasing ac­tivity were fully offset by decreases in dividend payments.

Even if we're determined to prove that modern, publicly traded com­panies are not investing sufficiently, returning excessive amounts of cash to shareholders does not appear to be the culprit.

You'll notice that stock buybacks and dividends are grouped together in the above paragraphs. This part is important: dividends and buybacks are the exact same thing, at least economically speaking.

In both cases, a company has cash it wishes to distribute to its share­ holders. In a buyback, it reduces its share capital by delivering cash to the shareholders, whereas in a divi­dend, it reduces its retained earn­ings.

These are simply two closely relat­ed line items on the balance sheet; the difference between them is triv­ial.

One thing I like to do as l assess the reasonableness of anti-buyback claims is substitute "buybacks" for "dividends" in arguments. No one is likely to have a problem with the substituted versions of these argu­ments.

On executive compensation: buy­backs can absolutely increase the amount paid to corporate execu­tives, particularly by impacting their long-term incentive (LTI) plans.

Columbia Law School research indicates that in 2016, LTI compen­sation made up 47.4 per cent of total compensation for CEOs of S&P 500 companies.

Of this LTI compensation, in­come-related measures like earn­ings-per-share (EPS) were used in 64 per cent of plans. Since stock buy­backs reduce shares outstanding, EPS is automatically increased, and CEOs stand to benefit.

Are buybacks a bad thing? As with many questions, the answer is: it de­pends.

Governance issues in publicly traded companies may be exploited by executives using buybacks, though the practice itself may not be inherently bad for the economy.

A less cynical argument may be that buybacks allow for the efficient allocation of capital, where compan­ies may distribute cash to sharehold­ers when they no longer have fruit­ful investments to make themselves. If the shareholders can then allocate these financial resources to their highest and best use, that's good for the economy as a whole.

Regardless of our views on the matter, buybacks are now a key facet of our capital markets and are likely to continue to be.

This writing is for general informa­tion purposes only and should not be considered to be legal, accounting, tax, or personalized financial advice. Any opinions expressed are those of the author and may not necessarily reflect those of Louisbourg Investments Inc.

This feature was originally published on page A12 of the Moncton Times & Transcript on Thursday, November 22, 2018. Reposted with permission.

About the Author

Emerson Savage, CPA

Associate Institutional Portfolio Manager
Emerson Savage is an Associate Institutional Portfolio Manager at Louisbourg Investments. Emerson joined the firm in 2016 after working in the finance division at a multinational conglomerate. In his role, Emerson helps lead institutional relationship management, guiding investment policy and asset allocation decisions for the firm’s pension, insurance, endowment, and foundation clients. Emerson also helps lead content generation and marketing efforts at the firm, having written in the past on issues such as stock buybacks and quantitative investment management. He holds accounting and finance degrees from the University of New Brunswick as well as the CPA designation.