Share buybacks are a good thing

A wide range of commentators, experts, and laymen have recently denounced share buybacks: where firms buy their own equity on the stock market, effectively deleting shares and raising the size of those that remain. These critics claim that share buybacks are a symptom of corporate short-termism: these firms, instead of investing in factories, skilled labour, information, research, premises and so on to raise their long term success, are merely boosting short-term returns. Thus, it is said, the managers of these firms are actually contributing to "secular stagnation"—slow growth around the world, not due to the business cycle—and the "productivity puzzle"—the surprisingly slow improvement in British and European output per worker and per hour.

But this is all wrong, and these critics are fundamentally mistaken. Buybacks improve stock market efficiency by pricing in inside information without harming outsiders, when firms know things their shareholders don't. They also free up funds to be invested in other firms: if firms repurchase shares they are effectively saying: at the current price it would be better to put our cash into other projects (perhaps in other firms); we have already funded all the investments with a cost:benefit ratio that passes muster at the current interest rate.

Start with a simple model of investment. You try and hold a portfolio of securities—bank deposits, bonds/gilts, and equities—based on how much risk you are willing to hold, and what your opinions are on the prospects of various firms, sectors, and countries, relative to the market. If you think Apple stock is worth more than the market price you hold more of it than the average investor; if you think China will grow faster than the average investor, you hold more Chinese assets; if you're investing for retirement in 50 years you hold more equities; if you're investing for a few years in the future you hold more bank deposits and gilts.

When a firm decides to buy its stock back, it will have to bid marginally above the market price to induce stockholders to sell, as well as accounting the mechanical price increase due to concentrating remaining holdings. Those stockholders who value the firm at exactly its current share price will sell first, and then those who value it marginally above the current price, and so on. But there is no reason to expect that the overall appetite for saving and investment has decreased: we should expect these investors to redirect this cash into whatever marginal investment they almost did instead of the firm in question. When Apple was £12/share they may have fancied it, but when it's £15/share Google might be more attractive.

Thus, overall investment is not affected by buybacks. It is merely redirected to better uses. The counterfactual is either overinvestment in upopular sectors and obsolete technologies, or conglomerate-isation. Should the rise of digital cameras prompt Kodak to (a) start up a digital camera division; (b) invest more in its existing business; (c) or focus on its profitable activities and let its investors go for Canon and Nikon. There is a case for (a), but history suggests (c) was the best strategy—companies suffer diseconomies of scope.

A new paper by Pascal Busch and Stefan Obernberger in the Review of Financial Studies (abstract, ungated earlier version) confirms the predictions of the simple intuitive model. They study data on US stock prices and find that repurchases enhance several measures of price efficiency, primarily by intervening when outsiders underrate firms' prospects in ways that insiders are sure are false. What's more, they can't find evidence that managers use buybacks to manipulate their own pay packets.

The message is clear: financial markets work well, and meddling with them can be costly!