Are Buybacks Evil?
It is often clear what is good, and what is evil. John Wayne was good. He wore a white hat and exacted justice on the cowboys wearing black hats, who were evil. When the Red Sox and Yankees play, we root for the Red Sox, we know they are good. We also know the Yankees are mean to old people, children, and puppies. Other times it’s not so clear. Theoretically clowns are good since their intent is to be funny and make us laugh, but there are many evil clowns out there too. A client responded to one of our recent market outlook pieces with this question, “I keep hearing that the record corporate earnings are mostly driven by buybacks, not economic growth"?
Depending on whom you listen to, you get very different answers on the good vs. evil aspects of buybacks. Let’s start by explaining how a buyback works. When a company is profitable it has many options on how to spend the profits. One option is paying their employees higher wages. Another is to invest in research and development for future growth. A company could also simply retain their earnings. Sometimes a company will spend their earnings and "buyback" their own stock shares. Why does a company buyback their own shares? That seems to be the question that has everybody yelling at each other. A bill currently proposed in the Senate that aims to limit buybacks states, “The surge in corporate buybacks is driving wealth inequality and wage stagnation in our country by hurting long-term economic growth and shared prosperity for workers. We need to rewrite the rules of our economy, so it works better for workers and not just for those at the top. This legislation makes it clear that empowering the voices of our workers and investing in our workforce is more important than using tax breaks and corporate profits to reward shareholders with more stock buybacks.” What this bill is referring to are the mathematics of a stock buyback. Here’s an example. If a manufacturing company makes $100 a year in profit and has 100 shares outstanding, it’s earnings per share would be $1 (100/100). If shares in the manufacturing industry are priced at 10 times earnings, the price of their stock would be $10 (10x1). If this manufacturing company spends their $100 profit on buybacks, it can repurchase 10 of its shares on the open market. The company now has only 90 shares outstanding. Here’s the new math after the buyback – Their $100 in earnings are now divided by only 90 shares outstanding. Earnings per share rise to $1.11 a share (100/90). Based on the 10 multiple, the stock is now worth $11.10 per share (1.11x10). Some argue that the winners are the shareholders whose stock went up 11%, and the corporate executives of the manufacturing company whose compensation is tied to stock price. The argument continues that the workers of the company did not benefit. Not only did they not get a pay raise, the earnings weren’t used to make a capital investment, (upgrade machines, new training, new products etc). If the company doesn’t invest in its future, there may not be a future. Workers might lose their jobs altogether. Of course, it’s never that straightforward. Corporate managements argue they know how best to spend their own money. Indeed, that is their job. Sometimes it makes sense to make capital investments or pay employees more, and some times it doesn't. Sometimes buybacks make sense and sometimes they don't. It al depends on the ROI (return on investment). What’s interesting about this debate is the diversity of opinion. Wall Street Titans like Blackrock CEO Larry Fink don’t like the practice of buybacks, “While we certainly support returning excess capital to shareholders, we believe companies must balance those practices with investment in future growth.” Investors like Warren Buffet love buybacks. “All of our major holdings enjoy excellent economics, and most use a portion of their retained earnings to repurchase their shares. We very much like that: If we think an investee’s stock is underpriced, we rejoice when management employs some of its earnings to increase Berkshire’s ownership percentage. Here’s is an example: Berkshire’s holdings of American Express have remained unchanged over the past eight years. Meanwhile, our ownership increased from 12.6% to 17.9% because of repurchases made by the company. Last year, Berkshire’s portion of the $6.9 billion earned by American Express was $1.2 billion, about 96% of the $1.3 billion we paid for our stake in the company. When earnings increase and shares outstanding decrease, owners—over time—usually do well.” Our job at GreenPort is not to judge right or wrong, our job is to understand economic impact. The original question posed to us was, are the increases in earnings per share being driven by buybacks? Many a perma-bear has argued that this bull market will collapse because earnings are fraudulent and a function of buybacks. We can’t deny the low interest rate environment has allowed companies to borrow on the cheap, write off the interest expense, and then repurchase their own shares. Buybacks have risen sharply.
This has definitely benefitted stock prices. We frequently mention that revenues have been increasing line with earnings. This is incredibly important. If earnings were simply a function of buybacks, revenues per share would be rising at a much slower rate than earnings per share.
We took an even deeper dive and found something very interesting. The majority of corporate buyback shares have been used for the issuance of stock as compensation to employees. The notion that companies use buybacks to reduce their share counts, and thereby boost earnings per share is not entirely false, but it doesn’t appear to be the primary motivator of buybacks. In Q4-2018, earnings per share increased 22.5%, while aggregate earnings increased 20.2%. Aggregate earnings, unlike earnings per share, aren't impacted by buybacks. If we simplify the math, that means buybacks roughly account for the difference, 2.3%. We are grateful for being asked this question. Your questions challenge us to dig deeper into our thinking. We now better understand the exact impact of buybacks. We hope you better understand this topic also. While you are always welcome to write or call us on any topic you would like us to explore, it's probably best to keep your questions to economics and investing. Although we do fancy ourselves quite skilled at movie reviews also. There’s always more to learn, The GreenPort Team