Stock Buybacks: Critics Have Missed the Real Problem

Their remedies cannot cure a misdiagnosed ailment

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Mar 14, 2019
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Companies’ stock buyback programs have come under the microscope in recent months, with a number of influential politicians and commentators calling for far tighter restrictions on the practice. Some have even suggested that the practice be banned altogether.

The present furor was ignited by a Feb. 3 op-ed penned by Senators Bernie Sanders and Chuck Schumer. In it, they contended that buybacks serve to enrich corporations and the shareholding class at the expense of workers and the public good. Unfortunately, they missed the real problems pervading the practice.

A soberer review of stock buybacks offers a clearer view of the problems, as well as solutions that might actually work.

A misdiagnosis and ill-conceived medicine

The problems cited by most critics of share buybacks tend to fall into two categories, which Sanders and Schumer highlighted in their original op-ed:

“First, stock buybacks don’t benefit the vast majority of Americans. That’s because large stockholders tend to be wealthier. Nearly 85 percent of all stocks owned by Americans belong to the wealthiest 10 percent of households. Of course, many corporate executives are compensated through stock-based pay. So when a company buys back its stock, boosting its value, the benefits go overwhelmingly to shareholders and executives, not workers.

Second, when corporations direct resources to buy back shares on this scale, they restrain their capacity to reinvest profits more meaningfully in the company in terms of R&D, equipment, higher wages, paid medical leave, retirement benefits and worker retraining.”

There are a number of serious issues with this characterization, as we have already discussed in a prior research note. For starters, the claimed rampant increase in buybacks at the expense of reinvestment is fundamentally ahistorical.

More importantly, however, is the simple fact that buybacks, like dividends, are not capital destructive in and of themselves. Sanders, Schumer and their compatriots are operating under a fundamentally flawed logic in this regard.

Here is a key point glossed over, or outright ignored, by critics of stock buybacks: Money used for buybacks is not lost. Rather, it is returned to investors and either reinvested in other, more profitable pursuits, or put back into circulation via spending on consumption. Either way, that is a good thing for the economy, not something to fret about.

As with any ailment, a misdiagnosis can lead to painful consequences. This is especially the case when the wrong diagnosis leads to the prescription of an ineffectual -- or even harmful -- treatment. Alas, this is exactly what has happened with much of the current leading criticism of stock buybacks. Take Sanders’ and Schumer’s proposed legislation, for example:

“Our bill will prohibit a corporation from buying back its own stock unless it invests in workers and communities first, including things like paying all workers at least $15 an hour, providing seven days of paid sick leave, and offering decent pensions and more reliable health benefits. In other words, our legislation would set minimum requirements for corporate investment in workers and the long-term strength of the company as a precondition for a corporation entering into a share buyback plan.”

Taken on its own, the proposed bill sounds like wishful thinking. In the context of the current political environment in Washington, where the Republicans control the Senate and occupy the White House, it comes across as empty posturing. That is unfortunate, since there are issues with the way buybacks work today.

The real sickness is in corporate governance

Attention is currently being focused in large part on ineffectual remedies for a nonexistent ailment. However, that does not mean there is nothing wrong with buyback programs under current rules.

The real issue has nothing to do with worker pay or other such politically charged points of contention. Rather, it is a matter of good corporate governance. The ultimate owners of a company are the shareholders, but they generally have little say in the day-to-day operations, especially of public companies. Instead, corporations are led by professional managers. In economic parlance, the shareholder base is the “principal” and the manager is their “agent.” In an ideal scenario, the incentives of principal and agent are aligned so that the agent acts in the best interest of the principal. In practice, this has often proven difficult to achieve. Managers and insiders have often been shown to engage in self-dealing practices, which can often result in poorer business outcomes and usually comes at the expense of shareholders.

A number of methods have been employed over the years to try to solve this principal-agent problem. One method that has seen great popularity in recent years is stock-based compensation. If the company does well, then the stock price goes up. Managers benefit directly, since their shares appreciate in value. With skin in the game, managers have an incentive to improve the business in order to see the value of their partial ownership grow.

Stock-based compensation makes intuitive sense and has proven popular in practice with many companies. However, that positive picture darkens when we bring stock buybacks into the mix. Managers can use buyback programs as a means of temporarily juicing the stock price in order to unload their shares at a premium. This creates a dilemma, which Securities and Exchange Commissioner Robert Jackson recently addressed:

“If executives believe a buyback is the right thing to do, they should hold their stock over the long term. Instead, we found that many executives use buybacks to cash out. That creates the risk that insiders' own interests — rather than the long-term needs of investors, employees, and communities — are driving buybacks.”

Thus, the effort to align the interests of shareholders and managers via stock-based compensation can, in some cases, result in unforeseen negative consequences. Of course, most companies that undertake buyback programs do so because they consider it to be a good use of cash that would otherwise be sitting around. Yet, there are some that have used buybacks to push the stock up, whether it makes particular economic sense or not. Such companies tend to underperform their peers, resulting in negative outcomes for shareholders.

A remedy for the real illness

The power to engage in buybacks gives managers the ability to enrich themselves in the short term, often at the expense of shareholders and the long-term interest of the companies they steward. That may lend credence to the arguments of critics like Sanders and Schumer. However, their proposed legal changes fail to address this much more tangible problem.

Thankfully, other ideas have been suggested that might actually work, while preserving buybacks as a tool for returning cash to shareholders and of overcoming the principal-agent problem. Senator Chris Van Hollen of Maryland, for example, offered one method of addressing the issue:Â "to prohibit these corporate executives from selling their stocks in a specific period of time around a stock buyback.”

This might be difficult to accomplish legislatively, due to the divided nature of government at the present time. But adoption of the idea might not require a legal or regulatory push. Indeed, companies have become increasingly sophisticated in their approaches to management. Some have implemented clawback provisions on compensation and bonuses, which allow them to reclaim awards to managers if their actions cause negative consequences later on. A similar approach to stock-based compensation could be employed.

Alternatively, the company could simply bar executives and directors from selling stock during the course of a buyback program. Quiet periods between earnings announcements can offer a template for such action at the company level, and might inform soft-touch legislative reform.

Ultimately, stock buybacks are worth preserving. In aggregate, the benefit the economy and investors by redeploying capital to where it will be put to best use. There is clearly an issue in the current way buybacks are done. Companies would be wise to adopt protective measures, even if a legislative remedy is unlikely to be forthcoming anytime soon.

Disclosure: No positions.