For the last few years, there has been a raging debate over stock buybacks - whether they represent a good use of a company’s capital, what effect they have on the broader market and even whether they should be legal at all.
Standard financial theory, as taught in Corporate Finance 101, states that buybacks are just a way of returning cash to shareholders, and that management teams should enact buyback programs when they have excess capital that cannot be redeployed effectively in the business. Furthermore, they should do this when the stock is trading at cheap levels relative to intrinsic value - which, as managers, they have the best insight into.
But not everything in life is as depicted on the pages of a textbook. There is a quote often attributed to baseball great Yogi Berra (although the wording is up for debate), and it goes: “In theory, there is no difference between theory and practice. In practice, there is.”
In an interview a few years back, activist investor Carl Ichan explained how corporate managers have been gaming the buyback system for their own benefit.
A day of reckoning
Ichan believes that many companies have been buying back stock to artificially increase their earnings per share, and they do this because of the free stock options that they are granted by their boards:
“They buy it back because they have options and they want their stock up, that’s all they really care about - that’s human nature...There are many companies out there that keep increasing their earnings because they’re buying back stock at very low interest rates and not in any way showing you the real earnings - they’re not depreciating correctly. And the analysts let them get away with it.”
Ichan went on to warn that businesses that engage in this kind of behaviour would face a "day of reckoning." While a temporary rise in a company’s stock price may be good for shareholders in the short term, in the long run it should be obvious that not reporting earnings correctly and spending large amounts of cash on buybacks (whilst ignoring reinvestment) will damage the business.
It’s ironic that this happens, because stock options are theoretically supposed to align the interests of managers with those of their shareholders. Incidentally, this is an opinion that Warren Buffett (Trades, Portfolio) has held for decades - he has always said that incentives can only align if managers use their own money to purchase stock, not if it is granted to them for free.
Ichan gave this interview a few years ago, before the coronavirus-induced market declines. Since March, we have seen first-hand the consequences of reckless share buyback programs.
For instance, despite years of record profitability between 2014 and 2019, all four of the biggest U.S. airline companies - American (AAL, Financial), United (UAL, Financial), Delta (DAL, Financial) and Southwest (LUV, Financial) - accessed emergency funding from the federal government under the CARES Act. As a group, between 2010 and 2019, the major American air carriers spent 96% of their free cash flow on share buybacks - money that was not available to support operations during the lockdown period. Today, Ichan’s warning seems more prescient than ever.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The US Federal Reserve Turns to Buying Individual Bonds
- Carl Icahn Reflects on His Early Experience of Losing Money
- Bill Ackman: Index Funds Will Take on a More Activist Role
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