In the old days, stock markets were a place where growing business could raise capital to expand. By taking on new shareholders, those businesses gave up some ownership in return for new money to build plants and equipment, hire workers, invent new products and expand into new territories. The economy benefited, and individuals and pension funds were given a chance to participate.
When the companies did well, they began to pay dividends. The individuals and funds who invested started to see a cash return on their investment, and the investment mantra of "buy and hold," espoused by Graham and Dodd, Warren Buffett, or Peter Lynch was in vogue.
Patient money was well-rewarded. An investment of $10,000 in Microsoft (NASDAQ:MSFT) in its 1975 initial public offering made those who kept their stock multi-millionaires. An investment in Buffett's Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B) held for decades likewise made its investors rich people.
How things have changed. Today, there is a lot less patient money. Activist investors like Carl Icahn or Bill Ackman are not content to be investors, but feel the need to interfere in the management of companies they tend to own for very short periods, shaking things up to pump up the stock price, and then getting out at a profit. The companies are not always better off as a result, just the activists and their backers.
CEO compensation has gone from providing a good living to a level many my age see as obscene. We now have pay packages including options and restricted stock units that reach hundreds of millions. The merry-go-round of option awards to management, who promptly exercise them and sell the stock in companies like Salesforce.com (NYSE:CRM), has resulted in management making millions, while the company remains virtually profitless.
Initial public offerings for young entrepreneurs are no longer opportunities to raise money to expand, but have become opportunities to cash in big time. The management of fledgling Twitter helped themselves to "stock-based" compensation totaling some $521 million on the IPO. About 50 people employed by WhatsApp saw their company sold to Facebook (NASDAQ:FB) for a whopping $19 billion, over $350 million for each person employed, just a few weeks ago. I wonder if these young, and now very rich people will remain motivated to pursue a long-term career, rather than turn their attention to high-class real estate, yachts and private jets. Early success has often led to tragic results for sports stars, rock stars and Hollywood actors, whose drug and alcohol problems and suicides fill the tabloids.
Along with all the changes in equity financing and management compensation schemes, some bright lights came up with the concept of "stock buybacks."
The traditional business model allowed all shareholders to share in the surplus cash flows the business earned from time to time through payments of dividends. Every shareholder got the same treatment. Finance professors at business schools taught MBA students that the value of a corporation could be considered the present value of all future dividends. Unfortunately, we don't know with certainty what future dividends are likely. Valuation remained a daunting task.
By tying CEO compensation to stock price, boards made the dividend decision a lot easier for CEOs. If the company pays a dividend, every shareholder gets paid, but the company has less money and the stock price typically falls by the amount of the dividend, other things being equal. That model of distributing cash to shareholders may treat shareholders equally, but on its own, it does nothing to raise the stock price. That will have to come from building the business, so investors believe that future dividends will be greater and bid the share price up.
CEOs who have exhausted their ability to find avenues to build their business typically had both MBAs and Excel spreadsheets, and soon discovered that an easier way to raise the stock price was the stock buyback. The buying itself tended to raise the price, and the same earnings with fewer shares outstanding increased earnings per share - adjusted, of course, for the interest on the funds used to buy back stock. Long-term shareholders get left behind by the buyback, of course, since they don't sell. They benefit only if the buyback is at a price less than the shares are actually worth, as if that was knowable, leaving a greater residue for the loyal (i.e., non-selling) shareholders to share in.
You would think that would result in large buybacks when share prices generally were depressed, and an absence of buybacks when markets tended to be overvalued. But that is not the case.
Buybacks have accelerated when stock prices were high and diminished when prices were low, while dividends have been fairly constant, declining only somewhat during the 2008-2009 recession.
Source: Wall Street Journal
Thirteen large cap companies each spent over $25 billion on buybacks in the past 5 years. Based on the earnings multiple of the S&P being in the mid-teens throughout that period, the companies paid, on average, something like fifteen times earnings to buy back stock. That means they earned the reciprocal of the price-to-earnings multiple, or about 6% to 7% on that investment.
All of those companies have returns on capital employed well in excess of 6% to 7%, and based on my experience on many public boards of directors, I would expect most would have cut off rates for returns on new investments at or above 15% after tax. Investing $25 billion at 7%, rather than at 15% reduces future earnings by $2 billion annually. That surely cannot be good for the company or its shareholders. For it to be good, companies that can earn 15% on equity would have to buy back stock at a multiple of about six or seven times sustainable earnings. That sort of opportunity is scarce today.
Across the S&P more broadly, buybacks in 2013 totaled $476 billion, while the market surged towards record levels. The previous high for buybacks was at the market peak in 2007, when buybacks hit a record $589 billion.
Investing $500 billion in buybacks at 15 times earnings, rather than investing $500 billion in new products, new oil wells, data centers, new software, new drugs or new stores reduced the earnings power of the S&P about $40 billion, or a cumulative $200 billion of annual profits foregone on buybacks carried out over the past five years. Over the next five years, the S&P 500 will earn $1 trillion less net income from its failure to invest those funds, more if the buyback binge continues.
So, who benefits?
The selling shareholders benefit by selling at historically high prices, of course. The remaining shareholders benefit if, and only if, the stock buyback was at a price less than the intrinsic value of the stock purchased and canceled, and even then, the benefit is necessarily less than if the funds were invested in productive assets.
The real beneficiaries are the CEOs. There can be no easier way to boost short-term earnings per share than stock buybacks. No operating risks. No pesky capital expenditure reviews. No need to hire more engineers, or deal with suppliers or customers. Those are inconveniences, at the best of times.
It is interesting to hear the President of the United States speak to economic issues like employment and deficits, while the leaders of American industry complain about regulation, policy changes and taxation. The fact is that the government is doing what governments can do to improve the lot of the American people, and corporate leaders are doing everything they can do to improve their own situation, whether or not that is good for the economy, their employees or their shareholders.
There are many theories about stock buybacks that suggest they are "returning capital" to shareholders. The fact is, they are not. Stock buybacks are more akin to paying severance to those leaving at the expense of those staying. Whether the remaining shareholders make out or not is a bet on the future, and when the buybacks occur at market peaks and diminish at market lows, the odds are pretty good that the future will punish the remaining shareholders, while rewarding the people they have appointed CEOs.
Shareholders who sold into the 2007 buybacks got $589 billion in cold hard cash. To the extent they sold shares, they avoided the 2008-2009 meltdown in markets and were able to double up at the bottom. Shareholders who remained took a bath. The companies that failed paid their CEOs anyway, often with large severances and pensions.
Stock buybacks perpetuate a Wall Street disease of one-sided bets. If the bets work out, CEOs and shareholders make out. If the bets turn sour, CEOs make out and shareholders get left holding the bag. That is, shareholders who did not sell into the buyback, of course.
With the stock market at all-time highs, investors should shun those companies that have big stock buyback programs. Those include Apple (NASDAQ:AAPL), Qualcomm (NASDAQ:QCOM), CP Rail (NYSE:CP), Home Depot (NYSE:HD), IBM (NYSE:IBM), WellPoint (WLP) and Lockheed Martin (NYSE:LMT), to name a few.
Stock buybacks announced and planned now total $1 trillion over the next few years, according to an article published by Canadian Press. As the article so correctly points out in its headline - "Stock buybacks nearing record numbers, but is that a good thing?"
In my view, it is not. I believe markets are near a top, and the stocks of companies with balance sheets depleted by big buyback programs will suffer more than most.
Good luck with your investing.
Disclosure: I am short AAPL, CRM, CP, QCOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.