Bought and Paid For
Jonathan Clements | October 21, 2017
STOCK BUYBACKS are here to stay. The Securities and Exchange Commission opened the door in 1982, when it ruled that companies could repurchase their own stock without triggering accusations of share price manipulation. Ever since, more and more companies have taken advantage. Indeed, in recent years, U.S. corporations have spent more money buying back their own shares than paying out dividends.
Good news? I see both plusses and minuses. Here are the plusses:
- Once you figure in buybacks, U.S. stocks may be less overvalued than the market’s dividend yield suggests. Today, the S&P 500 companies are paying 2% in dividends, below the 3% average for the past 50 years. But if you factor in today’s 2.4% buyback “yield,” the total payout is closer to 4.4%. In a recent paper, Philip Straehl and Roger Ibbotson point out that total payouts, along with the growth in those payouts, has better explained long-run stock market returns than dividends alone. Their total payout model produces a forecasted 5.1% after-inflation annual return, versus 3.6% if you analyze just dividends.
- Buybacks are a more tax-efficient way to return cash to shareholders. If a company pays a dividend, every shareholder who owns the stock in a taxable account will have to fork over a sliver to Uncle Sam. By contrast, buybacks cash out investors wanting to sell, without inflicting taxes on shareholders who stick around. Those shareholders benefit, because there are now fewer shares with a claim on the company’s earnings and dividends.
- New share issuance has long been the enemy of existing shareholders, who historically have seen their claim on the economy’s profits diluted at a rate of some 2% a year. Thanks to buybacks, shareholders across the U.S. stock market have, by some measures, suffered no dilution over the past decade.
Sound compelling? Offsetting these plusses are some notable minuses:
- While regular quarterly dividends are viewed by companies as a commitment they’re loath to break, stock buyback programs are often quietly dropped—and usually at the worst possible time, when the economy is struggling and share prices are at bargain prices. Corporations have proven to be terrible market timers, buying their own shares heavily in 2007, as stock prices neared their peak, and then abandoning their buyback programs during the market rout that followed. In the years since, as share prices have bounced back from their early 2009 low, so too has the amount of stock bought back.
- Because corporations have emerged as major buyers of their own stock, their terrible timing will likely exacerbate market movements, driving up share prices during bull markets, while removing a major source of buying power when markets tumble.
- Why are buyback programs shelved when the stock market is down sharply? No doubt part of the reason is fear, as corporations hoard cash during lousy economic times. But there’s a less savory explanation: When shares are down sharply, employees are less likely to exercise their stock options, so there’s less need to buy back shares to offset the resulting dilution. Indeed, a cynic might take today’s 4.4% total payout and view the 2% dividend yield as a reward to shareholders—and the larger 2.4% buyback yield as a lavish perk for senior executives. An obvious question: Has the ability to repurchase stock, and thereby hide the dilution caused by stock options, made companies more liberal in issuing options?
- Even if buybacks make sense for some companies, they won’t make sense for all companies. If corporations have extra cash, there are a variety of possible uses: They could pay dividends, buy back shares, purchase another company or reinvest in their own company. Buybacks can seem like the least bad choice: There’s no tax bill for current shareholders and no risk the money will be frittered away on a bum corporate acquisition or foolish capital spending.
But to make financial sense, buybacks should occur at prices that a company’s top executives consider lower than their stock’s intrinsic value. If that isn’t the case, they’re rewarding departing shareholders at the expense of longer-term investors. Even if top executives believe their stock is undervalued, buybacks may not be the best use of the company’s cash—if, say, the company could earn a higher return by reinvesting the money back into the company’s operations. Are corporations pondering such issues as they weigh whether to buy back stock? Somehow, I suspect not.
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