Back In The Spotlight
One topic of conversation that has garnered interest over the past couple weeks has been that of stock buybacks and questioning their acceptance in the markets today. The conversation surrounding this topic has been around since stock buybacks were allowed to begin again in 1982 thanks in large part to the Reagan administration. Prior to 1982, stock buybacks were banned on the premise that they were largely considered to be a form of stock manipulation due to the amount of money funneling into these stocks by the very corporations they represent an ownership stake in. Recently, this topic was brought back into the spotlight due to an article written by Bernie Sanders & Chuck Schumer for the New York Times where they laid out the argument that corporate buybacks, in their entirety, are a form of corporate self-indulgence that becomes the focus of where to funnel extra cash most corporations end up with. In the long-term this harms both the corporations and the economy. Throughout this post, I’ll further explain that premise and note a few alternative ways these corporations could spend that extra capital.
The Financial Statement Effect of Buybacks
Over the past 3 weeks, it’s largely been considered “earnings season” where many publicly-traded companies report their financial results for the past quarter or ‘fiscal year’ (cumulative past 4-quarters’ numbers). One big thing I’ve noticed each earnings season is the tunnel-vision-like focus that lies on two specific reported numbers for most companies.
The first of those numbers that gets the spotlight is revenue (i.e. sales). In expanding my knowledge base on financial statement analysis over the past couple years, I’ve learned to focus a notable amount of my attention on revenue. I personally focus on revenue because I believe, in most cases, it is the foundation of “growth” for a company. For a company to spend more money in hiring more people, building more facilities, etc… it must first grow it’s revenue so it has more money to spend on those endeavors. Additionally, and maybe more importantly, I find revenue is one of the reported numbers that is harder for management to manipulate. For example, let’s look at Net Income as a comparison. If a company is expected to make $890M in net income this quarter, they can cut costs (e.g. laying off employees, reducing benefits, etc…) throughout the quarter based off of how much revenue they take in, in order to ensure they are able to report a net income of $890M at the end of the quarter. This wouldn’t necessarily mean the company is any better off than they were last quarter, they were just simply able to adjust expenses to make it seem as if they met expectations of being better off this quarter. With revenue on the other hand, you can’t simply cut costs or categorize expenses differently to boost it. You’re more-so stuck with whatever revenue you can derive based off of consumer demand. Though, this is not absolute. Companies can (and have) boosted their revenue via related business transactions, where companies that have an ownership relation to theirs are utilized to boost sales. Also, revenue can be manipulated via a concept called ‘Channel-Stuffing‘. Channel-Stuffing is where companies send large orders of products to distributors prior to earnings so they are able to account for those orders under ‘Accounts Receivables,’ which are a component of overall Sales and Revenue. They do this knowing the distributors are going to be unable to sell the product, and likely return them, but for the mean-time they are able to boost their revenue. However, one is able to see this correlation of increased sales with an almost identical increase to accounts receivable, making it easy to notice.
The other number that I’ve noticed gets almost equivalent spotlight intensity each reporting season is Earnings Per Share (EPS). EPS is a metric I am much less of a fan of. In concept, EPS is to be considered the portion of the company’s profit that could be allocated to each share of their stock. It is important to note that this does not mean the shareholder is entitled to that portion of profit however. So if a company reported EPS of $0.39, it would conceptually mean that the company made $0.39 of profit for every share of stock owned by a shareholder. However, EPS is HIGHLY susceptible to accounting manipulation by management. The calculation behind EPS is essentially: (Net Income – Preferred Shares’ Dividends) ÷ # of Common Shares held by shareholders. This leads us to part of the big issue behind corporate stock buybacks. To illustrate, let’s say a company has 11 million shares held by shareholders in the market. Let’s also say this company wasn’t able to boost their revenue enough this quarter nor cut costs enough to meet the profit they would need in order to report the EPS number expected by the markets. If management knew this ahead of time, they could instead spend some (or all) of their excess cash to buying back shares of their stock from the market. This in turn, would lower the number that their Net Income is divided by. In short; $10 profit/10 shares = $1 EPS & $10 profit/5 shares = $2 EPS. The concept behind placing value on EPS is that the 10 shares an investor holds in the stock is ‘worth’ $2 of the companies profits rather than $1. In a company that’s growing, making efficient investment decisions with their capital, and making smart business decisions in general, this growth of $1 EPS to $2 EPS is beneficial seeing as that growth would be coming from ‘Net Income’ growing rather than ‘# of Common Shares held by Shareholders’ shrinking. However, the market doesn’t always seem to be efficient. Much of the market seems to simply look at that EPS number, rather than look deeper into how that number came to be what it is.
Management Bias
One other note of contention here is the management bias in favoring stock buybacks. As many of you might already be aware, much of corporate executive compensation annually is tied to some variable(s) of the companies performance each quarter and year. For example, the CEO may be entitled to 45,000 shares of the companies stock IF the company hits the EPS expectations of the market in their next reported earnings. The CEO in this example could likely work towards this goal (or steer the company toward this goal) via multiple routes, however if the company happens to have enough excess cash on hand, it could be argued that the route that takes the least effort would be simply to buy back enough stock so the denominator in the EPS equation (what Net Income is being divided by) would be small enough to guarantee the EPS result the market is expecting. There’s less uncertainty in that decision as well seeing as it will inevitably come down to the math behind the equation. If on the other hand, the CEO influenced the decision-making process to shoot for that EPS growth via boosting their revenue, the route on that front would likely contain much more uncertainty. If they were gonna chase that goal via a new product line, or M&A activity, there’s no guarantee that the results would match the expectations. To some degree, the results would be in the hands of the consumers. Additionally, the fuel added to a stock’s price via buybacks is huge, it is millions of dollars being pumped into buying that stock. This in turn boosts the price. Well as the price of the stock is being boosted via the company pumping it’s excess cash into buy orders, guess who’s bonus of 45,000 shares is worth a heck of a lot more thanks to that boost in price? The CEO’s. As one can imagine, this conundrum can lead management to make inefficient decisions with corporate cash piles. Add into the situation that current stock prices relative to historical standards are at some of the highest levels ever seen, despite a lack of revenue growth over the past year & it’s easy to picture that much of the buyback activity over the past year has been by companies buying their stock back at its’ most overpriced levels in the past 20 years. Talk about a poor return on investment. If however, they waited for the cyclicality of the market to take effect and push stock prices back down, they would be able to buy back more shares for the same amount of money & could likely see the shares they bought back from the public rise in price over the months following the buyback rather than drop in price.
Alternative Uses
Within the piece written by Schumer & Sanders, they note “Between 2008 & 2017, 466 of the S&P 500 companies spent around $4 Trillion on stock buybacks, equal to 53% of profits. An additional 40% of corporate profits went to dividends. When more than 90% of corporate profits go to buybacks and dividends, there is reason to be concerned.” Furthermore, “Fueled by the Trump tax cut, in 2018, United Stated corporations repurchased more than $1 trillion of their own stock.” These numbers are staggering. One alternative use of that cash that many argue would lead to a more beneficial return is R&D. Another of note is raising wages, paid medical leave, retirement benefits and training programs. While I think much of this can be argued this way & or that way, the Schumer & Sanders piece noted, “Recently, Walmart announced plans to spend $20 billion on a share repurchase program while laying off thousands of workers and closing dozens of Sam’s Club stores.” While it’s hard for me to argue that society should be able to tell corporations how to spend their excess cash, certainly it’s not hard to see that there is a moralistic problem here that needs to be addressed somehow. How? That is the harder question to answer.
Long-Term
One of the biggest issues long-term relates to the return on capital concept I previously touched on. Historically, buybacks have peaked during times when stock prices were peaking as well, concluding in a “buy at high-price” result rather than “buy-low, sell-high” mentality you want in investing.
Additionally, this buyback mentality has the effect of diverting funds from long-term economically beneficial concepts, such as wage growth. This hurts the majority of consumers as the excess cash that could raise there wages (& subsequently their spending) is instead diverted towards stock buybacks. Meanwhile, the benefits from boosted stock prices largely goes towards increased savings for the wealthy rather than increased spending. If on the other hand, we saw increased spending by consumers, that excess cash would serve as added fuel to the economy, helping it expand.
Conclusion
As I’ve laid out throughout this post, the reasoning behind the ban on corporate buybacks prior to 1982 definitely had validity. Since the ban on buybacks was lifted, time & time again we’ve seen corporations overuse their ability to buyback shares much to the detriment of their employees, investors, and subsequently the economy over the long term. While the buyback system can benefit the 1% within executive suites, the consequences associated with buybacks have significantly outweighed the benefits for the remainder of stakeholders throughout the market & society.
ZSV