Are financial markets fundamentally broken? If you read Charlotte Pickles’ article on share buybacks, then you would be inclined to think so. She argues that firms are forgoing real investment and engaging in ‘financial engineering’ to artificially meet earnings targets at the expense of long-term shareholders and the wider economy. In fact, she argues that buybacks are the key driver of the post-2009 stock demand. Perhaps unsurprisingly, I disagree.
The problem with Pickles argument is that it relies upon incomplete analysis and financial myths. A recent paper from hedge fund superstar Cliff Asness’s team at AQR Capital separates myth from fact.
1. Let’s start with the headline – “US companies spent $2 trillion buying their own shares in the last five years. Money that could have been spent on R&D, workforce training or higher pay for their workforces.”
As I tweeted earlier, this is only a problem if the previous shareholders burned the money. As Asness points out: ”investors’ proceeds from share repurchases do not simply disappear. Rather, these funds are received by equity investors, who can (and do) allocate the proceeds elsewhere, thereby funding other investments”.
But there’s a wider point, Pickles has the causation backward. Firms do not forgo profitable investments to repurchase shares, rather firms repurchase shares because of a lack of profitable investment opportunities. It may be the case, indeed it seems likely, that the most profitable investment opportunities will be pursued not by large, old firms but by nimble young companies.
As my former colleague Ben Southwood puts it, “Would it have been better to try and invent smartphones through existing camera companies like Kodak? Would on-demand video have turned out better if Blockbuster, not Netflix, had been the first big player? There is a reason that young entrepreneurs and start-ups have grown to dominate some businesses, creatively destroying older players in the process. Young firms are nimbler and more flexible and manoeuvrable.”
2. Pickles claims that the reason firms engage in buybacks is “because fewer shares means higher earnings per share (EPS) – the magical measure of corporate success that Wall Street watches.”
This is a common objection to buybacks. There is an intuitive appeal to the idea that CEOs are buying back shares to game earnings growth targets. The problem is that this strategy simply doesn’t work in the long run.
Back to Asness: “The idea is that by repurchasing shares, a company decreases its share count and thus mechanically increases its earnings per share. The problem with this argument is that it ignores the fact that decreased cash means lower earnings, either due to less interest earned on the cash or the loss of returns from other uses of the cash.” If a firm is leaving profitable investments on the table to fund buybacks, then their EPS should fall in the long-run.
Asness goes a step further, he compares EPS growth rates for firms in the Russell 3000 (a leading stock index) that engage in share buybacks and firms that don’t. He finds no link between share buybacks and EPS growth, in fact firms that do not engage in buybacks have higher EPS growth. This he points out is what we would expect given that firms buyback stock when they lack investment opportunities.
There’s a caveat here. A well-timed buyback ahead of an earnings announcement could artificially boost quarterly EPS, though not long-run EPS. But, there’s no evidence that this is the primary motivation. If it was then investors could very easily modify executive compensation to adjust for repurchase effects. This, by the way, is already done for dividends for employee stock options.
3. Pickles claims “Buyback isn’t actually good for shareholders (at least not long-run investors)”
She cites a study by McKinsey Analysts which finds “Based on a sample of 250 non-financial S&P 500 companies McKinsey analysts found no link between share repurchase intensity and total return to shareholders.” Furthermore, she claims “just three of the ten largest share repurchasers since 2003 have outperformed the S&P 500 Index.”
That sounds persuasive, but it’s important to remember why firms engage in buybacks in the first place. Firms issue shares when they want to raise capital and pay back capital when they lack profitable investment opportunities. Firms therefore engage in buybacks because they are pessimistic about future investments, so the McKinsey results do not actually prove that repurchases lead to worse performance. More likely is that firms expecting to underperform the S&P 500 are more likely to engage in buybacks.
There’s good evidence that this is the case. It is hard to separate correlation from causation when studying financial markets as share prices reflect the expected long-run value of a stock. But, one way we can identify whether repurchases hurt or helped share prices is by looking at how markets respond to unexpected announcements. According to Asness, the academic evidence finds “the announcement impact on returns of share repurchases is between 1 and 2% on average.” In other words, the best evidence we have is that buybacks increase share prices.
Why is this the case? There’s three reasons:
1. It signals that management believes that the company’s shares are currently undervalued.
2. If buybacks are debt-financed, then the company’s tax burden will fall as debt-interest payments are tax deductible.
3. Investors don’t like large cash reserves as managers who aren’t owners may be tempted to use the cash pile for empire building.
When it comes to stock buybacks, we should follow the advice of Bart Simpson – ‘Don’t have a cow man!’.
