A divided Washington has unified around an unlikely issue: the record pace of share buybacks by US companies. This rare unity heightens the risk that the Congressional sausage factory spits out laws that will have negative consequences for companies, the economy and investors.
There’s also the matter that the ire of certain senators in Washington about share repurchases, which have very much been a feature of the post financial crisis era, misses a very important issue, the proclivity of companies selling debt to fund their buyback activity.
The buyback trend, like many in finance, has expanded beyond the US markets across the world, including Japan. Should Washington follow through on one proposal of taxing buybacks at a higher rate, or veer left and ban them unless a company bolsters pay for its employees, the outcome will resonate globally.
What binds some Republican and Democratic senators is the notion that buybacks need limiting to encourage companies to invest more in their operations. But the politicians are missing a key point. Buybacks often reflect the fact that a strong business model is generating a surfeit of cash, a situation that tends to attract activist investors demanding higher dividends and buybacks, as was the case with Apple.
For the long term health of the economy, it’s far better that excess cash is returned to investors. They can find more promising ways to deploy that money, including investing in companies that can make better use of the funds and generate a higher return on capital.
Buybacks also provide some important flexibility for companies, unlike dividend payments that are expected to rise over time. A buyback can be curtailed should a more pressing use of the cash arise during, for example, an economic downturn. It explains the popular view in C-suites that buybacks are like dating, whereas dividends represent a marriage with investors.
Another charge against buybacks is that management is simply trying to boost the value of their shares, particularly given the incentives built into executive compensation. That’s not the whole story as the repurchase of common equity involves the exchange of cash, an asset already held by the company, to investors via a cut in the number of outstanding shares. The reduction in the share count offsets the cash being returned.
The S&P buyback index, which contains the 100 companies that have bought back the most shares, has generally beaten the broad market in good years but, amid record buyback activity in 2018, trailed the S&P 500.
At first glance you can see why some link buybacks to strong share price performance, but that conveniently ignores how companies generating massive amounts of cash and already investing in their business, generally perform well and are sought by investors. In the case of large technology groups, which manage big buyback programmes, they have led Wall Street for much of the past decade.
The buyback scorecard from 2011 to 2018, in terms of net dollars spent, is dominated by the technology sector (25.8 per cent), healthcare (13.8 per cent), and financials (13.3 per cent), according to Morgan Stanley. Analysts at the bank conclude: “Share buybacks have been a meaningful tailwind for long-term equity returns post crisis, but are not a principal return driver.’’
Where some criticism of buybacks is warranted is how debt has been used to finance them — a significant feature of the post-crisis period.
Andrew Lapthorne and his colleagues at Société Générale note a very pronounced relationship between companies (excluding financials) which have bought back shares and the annual change in corporate debt up until last year.
It was then complicated by tax reform, which encouraged companies to repatriate money they held overseas. Before 2018, many US multinationals tapped debt markets to fund buybacks rather than pay US corporate tax on foreign earnings.
A justifiable concern is that other companies have weakened their balance sheets to fund buybacks, leaving them looking vulnerable when the economy eventually flirts with recession. Such an outcome, as was seen during 2009 into 2010, will sharply reduce buyback activity. As in any cycle, companies with low-quality balance sheets will pay the prices for excess leverage.