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8-11-2011: The Argument for Share Buybacks

As the market reacts to fear and rumors (France’s credit rating will be downgraded or that Societe Generale is on the brink of bankruptcy), one thing is clear, at present, U.S. corporations hold record amounts of cash; somewhere near two trillion in all.  Fearful of the future and too many uncertainties, corporate executives have refrained from large capital expenditures and adding headcount.  Forced to wonder whether the U.S. is in another recession or whether there will be consumer demand to meet increased productivity, many executives have opted to hoard cash like it’s their job.  With money market funds and U.S. Treasuries offering very little yield, I believe corporations should return some of their cash stockpile to shareholders. 

First, let us remember shareholders are, without any misgiving, entitled to their share of cash as they are the owners of the company.  Even traders, for the time they own the shares, are owners of the company.  Management, ultimately, must answer to the shareholders. 

Individual investors would benefit if management returned surplus cash to their hands.  This would serve three purposes in my mind.  First, much like I believe individuals are better at allocating capital than governments, I believe individuals will allocate capital to best suit their needs much better than a corporation.  Currently, corporations are merely building an unnecessarily high buffer while shareholders live paycheck-to-paycheck.  Second, given the current dismal state of many Americans’ financial picture, individuals would most likely welcome any extra cash to meet their bills or spend elsewhere.  In any case, both would create a positive ripple throughout our economy in the form of lower defaults or increased consumer demand.  It’s possible, too, that the savings rate increases.  Third, as the market exposes itself and opportunities come along at these price levels, I, along with other investors, would like to have more capital to take advantage of the prices the ticker offers.

A side effect of returning cash to shareholders would be to provide a bottoming out in the share price.  The fear running around Wall Street and abroad would subside and market volatility would be reined in.  Granted, this is not a panacea for the world’s problems, but it would undoubtedly help restore confidence to the markets and Main Street.  Even regular Joe, whose mutual funds and retirement account has been badly beaten up, would likely see increases in value given most of the blue caps are the main culprits of hoarding cash. 

Boards and corporate executives argue that share repurchases and dividends send a negative message to shareholders.  That is, management failed at finding worthy projects and they have nothing better to do with the company’s cash.  I disagree; the purpose of investing is to realize a return in both capital gains and dividends.  Share repurchases and dividends satisfy that goal. 

How companies go about returning cash to shareholders is up for debate.  Repurchasing shares and dividends both have their pros and cons.  Share repurchases avoid the double taxation facing dividends but introduce the complexity of setting a fair price.  From the corporation’s perspective, buying undervalued shares is certainly good for the remaining shareholders.  For the selling shareholders, however, that deal is less than fair.  On the flip side, corporations that buy overvalued shares fair no better.  Remaining investors will have been cheated while those who sold received more than the fair value.  Share repurchases are fair and just only when the price paid/received is at a reasonable price.  The other options, dividends, is less attractive because they are subject to double taxation; once at the corporate level and then again at the individual level.  However, it does avoid the fairness obstacle.  Although, one could argue dividends is not an efficient use of company money because of double taxation (assuming a taxable account). 

At current prices, corporations would do well to offer share buyback programs above current market prices to their shareholders.  Offering buybacks above the market level would increase the market price of the stock and prevent further slides.  At the same time, those investors who partake in the share buyback programs will benefit from not having to sell their stock at depressed levels.  The remaining shareholders will see their holdings increased in both value because of increased share price and higher earnings per share.