Written by Lance Roberts, Clarity Financial
“Few topics prompt as powerful (and violent) a response from financial professionals as what the role of financial buybacks is in determining stock prices.
One group, largely those bulls who after a decade of central bank manipulation still believe that markets are efficient and unrigged, argue that stock buybacks have no impact on stock prices.
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The other group, those who actually understand that if there is a trillion dollars in price indiscriminate stock bids is the single most effective way to boost stock prices, know that corporate buybacks, which until not too long ago were banned, and which over the past decade emerged as the single biggest source of stock purchases, are one of the two most important factors behind the all time highs in the stock market (the other being the Fed, whose policies have allowed companies to issue debt with record low yields, allowing them to fund these trillions in buybacks).” – Zerohedge, April 4, 2019
It is an interesting debate.
What makes this debate particularly notable, and as noted above, most people don’t remember that share repurchases were banned for decades prior to President Reagan in 1982.
So, why were they banned in the first place? Via Vox:
“Buybacks were illegal throughout most of the 20th century because they were considered a form of stock market manipulation. But in 1982, the Securities and Exchange Commission passed rule 10b-18, which created a legal process for buybacks and opened the floodgates for companies to start repurchasing their stock en masse.”
This isn’t the first time we have reversed policy previously put into place to avert Wall Street from taking advantage of the market to fill their own coffers.
The Crash of 1929
Leading up to the crash of 1929, banks, which were entrusted with people’s life savings, were on both sides of the investment game. They loaned money to investors to speculate with, and they were speculating in the markets themselves. What could possibly go wrong?
“Stocks are now at a permanently high plateau” – Dr. Irving Fisher, 1929
Following the crash, the SEC was formed to “police” the financial markets and protect investors from the predatory practices of Wall Street and the Banks. Part of that process was the passage of the Glass-Steagall act in 1933 to separate banking and brokerage activities in order to build a wall between the source of funds (bank deposits) and the use of funds (speculative investment.)
For nearly 70-years the markets functioned properly. However, in 1999, Congress repealed Glass-Steagall under tremendous pressure from the major banks who lobbied heavily to gain access to the massive revenue being generated from the “dot.com” mania.
It didn’t take long.
Just seven short years later, the world came apart in the biggest crisis/recession since the “Great Depression.” Not surprisingly, at the very center of the financial and economic destruction, were the major banks taking advantage of the investing public once again.
Coincidence?
“History may not repeat, but it often rhymes.” – Mark Twain
As noted, for decades stock buybacks were banned due to the problem of potential market manipulation. It is important to remember that regulations are NEVER passed in ADVANCE of a problem, they are always imposed in RESPONSE to a problem.
What Are We Talking About?
Like stock splits, share repurchases in and of themselves are not necessarily a bad thing, they are just the least best use of cash. Instead of using cash to expand production, increase sales, acquire competitors, or buy into new products or services, the cash is used to reduce the outstanding share count and artificially inflate earnings per share. Here is a simple example:
- Company A earns $1 / share and there are 10 / shares outstanding.
- Earnings Per Share (EPS) = $0.10/share.
- Company A uses all of its cash to buy back 5 shares of stock.
- Next year, Company A earns $0.20/share ($1 / 5 shares)
- Stock price rises because EPS jumped by 100%.
- However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
- The next year Company A still earns $1/share and EPS remains at $0.20/share.
- Stock price falls because of 0% growth over the year.
This is a bit of an extreme example but shows the point that share repurchases have a limited, one-time effect, on the company. This is why once a company engages in share repurchases they are inevitably trapped into continuing to repurchase shares to keep asset prices elevated. Share repurchases divert ever-increasing amounts of cash from productive investments and takes away from longer-term profit and growth.
As we just discussed last week, since the recessionary lows, much of the rise in “profitability” has come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. While tax cuts certainly provided the capital for a surge in buybacks, revenue growth, which is directly connected to a consumption-based economy, has remained muted.
The reality is that stock buybacks create an illusion of profitability. Such activities do not spur economic growth or generate real wealth for shareholders, but it does provide the basis for with which to keep Wall Street satisfied and stock option compensated executives happy.
Don’t believe me?
In 1982, according to the Economic Policy Institute, the average CEO earned 50 times the average production worker. Today, the CEO Pay Ratio’s increased to 144 times the average worker with most of the gains a result of stock options and awards.
As shown in the chart below, clearly profits aren’t being shared with “working class stiffs.”
Tax Cuts For Corporations
As I wrote in early 2018. while it was widely believed that tax cuts would lead to rising capital investment, higher wages, and economic growth, it went exactly where we said it would. To wit:
“Not surprisingly, our guess that corporations would utilize the benefits of ‘tax cuts’ to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks. This is ‘financial engineering gone mad'”
Share buybacks are expected to hit another new record by the end of 2019.
Let’s clear up a myth used to support the benefit of stock buybacks:
“Share repurchases aren’t bad. It is simply the company returning money to shareholders.”
Here is the issue:
Share buybacks only return money to those individuals who sell their stock. This is an open market transaction. For example, when Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital from the buyback are those who sold their shares.
So, who are the ones mostly selling their shares?
As noted above, it’s the insiders, of course, as changes in compensation structures since the turn of the century has become heavily dependent on stock issuance. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:
“Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.“
A recent report on a study by the Securities & Exchange Commission found the same:
- SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.
What is clear, is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:
“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”
In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market.
Don’t Have Cash, Use Debt
The other problem with the share repurchases is that is has increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance.
Furthermore, with 62% of investment grade debt maturing over the next five years, there are a lot of companies that are going to wish they didn’t buy back so much stock. This debt load will become problematic if rates rise markedly, further deterioration in credit quality locks companies out of refinancing, or if there is a recessionary drag which forces liquidation of debt. This is something Dallas Fed President Robert Kaplan warned about:
U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.
A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’
The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.
This was recently noted by the Bank of International Settlements.
“If, on the heels of economic weakness, enough issuers were abruptly downgraded from BBB to junk status, mutual funds and, more broadly, other market participants with investment grade mandates could be forced to offload large amounts of bonds quickly. While attractive to investors that seek a targeted risk exposure, rating-based investment mandates can lead to fire sales.”
Make Stock Buybacks Illegal?
Now that you understand the background, and who share buybacks actually benefit, you can understand the reasoning behind wanting to ban them once again.
While share repurchases by themselves may indeed seem somewhat harmless, it is when they are coupled with accounting gimmicks, and massive levels of debt to fund them, in which they become problematic. This issue was noted by Michael Lebowitz:
“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”
However, there are significant consequences in resetting the system.
“Eliminating buybacks would immediately force firms to shift corporate cash spending priorities, impact stock market fundamentals, and alter the supply/demand balance for shares… The potential restriction on buybacks would likely have five implications for the US equity market: (1) slow EPS growth; (2) boost cash spending on dividends, M&A, and debt paydown; (3) widen trading ranges; (4) reduce demand for shares; and (5) lower company valuations.” – David Kostin, Goldman Sachs
If you are a short-term stock market bull, you will probably not want that. However, as my friend Doug Kass notes there are long-term benefits to reforming the system and putting corporations back onto a more “economically friendly” level:
My plan is simple.
Make buybacks illegal.
Allow companies to dividend out cash tax-free, like a buyback. This keeps companies out of the market and prevents them from manipulating their own stock, which often benefits company insiders who are selling.
Then the decision of what to do with corporate cash becomes more pure.
It no longer will be a choice of trying to prop up a stock versus spending it on the business.
Companies will still be left to do with their own cash what they want.
This is the other big problem, the fact that dividends are taxed, but buybacks are not.
That doesn’t make too much sense to me.”
In the end, the S.E.C. will move to once again ban stock buybacks as they did once before.
Unfortunately, it will be in response to (not to mention the pressure of public outrage) the next financial crisis that devastates a vast majority of the U.S. economy.
But that is just the way the system works.
See you next week.
