When CEO has cash to spare, what are some of the options that he has? He/she can do one of the 3 things;
- Sit on it and probably invest in some short term securities
- Invest in new projects / R&D / Capex
- Return the cash to shareholders via either dividend or share buyback
Option 1 is generally frowned upon by investors. For option 2, higher investment does not generally lead to higher expected returns. Finally for option 3, redistributing wealth has been viewed positively by investors. This can come in the form of dividends, retained earnings and the popular buyback strategy.
The Share Buyback Phenomenon
Share buybacks have generated a lot of attention within the low-yield environment that we are in right now. For example, in 2017, we saw Apple commit to a program to return $300 billion to shareholders by March 2019. $210 billion of this would be in the form of a share buyback.
At a time when the cost of money is ultra cheap, some companies find it better to repurchase stock rather than pay down debt, since the return is greater in a rising stock market. Companies who bought back shares from 2014 to 2017 have earned substantial capital gains that are far greater than the interest paid on debt.
Share buybacks could also be a signal that the company is confident in its business and is willing to reinvest its cash to purchase its own shares. At the same time, they may also repurchase its shares when it genuinely thinks they are sufficiently undervalued and doing buyback is the best way to utilize capital.
As long as the company is highly free cash flow positive (like Apple), the share buyback adds value by shrinking the share count. Remaining shareholders now have a larger portion of the earnings pie in the future. Plus, companies that do pay dividend lower their dividend expense because they have less shares to pay a dividend too. This strengthens their dividend payment ability and allows them to pay higher dividends in the future.
Creating a False Market
Companies buy their own shares because it makes the stock price go up. Executives approve buybacks because it benefits them to make their stock price go up. Investors like it when stock prices go up, so they generally cheer buybacks. Everyone’s happy with buybacks.
Although it should be done when prices are at their lows, management may abuse it to boost their Earnings per Share (EPS) and/or share price. This is worse when the share price is already overvalued, or by doing this they have under invest in innovation, skilled workforce or essential capex necessary to sustain long term growth.
The simple truth is this: Stock-based instruments make up the majority of the management’s pay and in the short term buybacks drive up stock prices which ultimately benefits them.
In other words, some CEOs are managing their companies’ buyback programs in order to increase their bonuses.
Furthermore, the share price rise caused by the repurchases will merely bring a new set of even more ignorant investors into the shares, attracted by their apparent “momentum.”
If this isn’t stock manipulation, I don’t know what is.
Now I’m not saying that stock buyback is totally bad or should be banned.
At the end of the day, it is the Board that should hold management accountable, and which in turn should be held accountable by shareholders. Manipulating the stock price certainly feels good in the short run as shareholders have benefited alongside with the management. However, repurchases made at high unsustainable valuations will harm the long term financial health of the company.
GE’s experience is a perfect example. Management bought back shares in the high 20s. With the stock now below $10, this is just pure destruction of shareholder value. The Board is being replaced and the management has already been replaced.
In the end, it’s not the executives who get hurt. It’s the employees, mom and pop investors who will see their portfolio and retirement sum decline.
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