The Controversy that is Share Buybacks

A strong economy, stagnant wages, and newly lower corporate tax rates have free cash flow gushing at US companies. Unsurprisingly, a lot of this cash is being spent on share buybacks. Goldman Sachs expects the boards of US companies to authorize a record $1 trillion in share buybacks this year, up 46% over 2017 and well ahead of the previous annual record reached in 2007. 

This surge in share buybacks has been accompanied by a surge in criticism of them, including calls to ban them. Clifford Asness, founding principal of AQR Capital Management, succinctly pushes back against this criticism in the Wall Street Journal earlier this week. I won't repeat Asness' arguments, but I will present the concluding paragraph from his opinion piece:

I agree with Asness on the topic of share buybacks and I hope that it will head off future uninformed nonsense about them. If I had written the article (and I wish that I had), I would have included two other points:

1) Share buybacks are a more tax efficient way for companies to return excess cash to shareholders than the alternative, cash dividends. In taxable accounts, dividends trigger taxes now, whereas share buybacks do not trigger any taxes for long-term owners of the company. These long-term owners will eventually pay a capital gains tax when they sell their shares, but it will be later, and at an equal or lower rate, than for owners of companies which pay out their excess cash in the form of dividends.

2) Company boards seem to be just as poor at timing the market as investors. Refer back to the chart at the top of this blog post. Notice that the previous peak in US share buybacks was in 2007, and that the trough in share buybacks was in 2009? As you may remember, the S&P 500^a peaked before the Great Recession at 1565.15 on October 9, 2007. Back then companies were paying a buck fifty for each dollar of forward year sales (the price to sales ratio shown in the chart below) — and doing so aggressively (~$750 billion in executed share buybacks in 2007). But when the S&P 500 bottomed at 676.53 on March 9, 2009 and valuations had nearly halved (~83 cents for each dollar of forward year sales), companies seemed disinterested in buying back their shares — 2009 executed share buybacks only reached $175 billion).

Fast forward to today, the S&P 500 closed the week at 2,850.13. US companies may spend close to $1 trillion buying back their shares this year at a valuation of over two dollars per dollar of forward year sales. Just like the average investor, company boards have a penchant for buying high, and selling low.

So here's my bottom line on the subject of share buybacks. Companies should return cash to shareholders if they do not have the ability to put it to work in projects that have positive risk-adjusted returns — the very definition of excess cash. There are two ways for companies to return this cash to shareholders, share buybacks and dividends. Share buybacks are the superior method to return this cash because of their lower taxation, but only if the share buybacks can be conducted at a fair to attractive price. Paying a buck a share that's intrinsicly worth only 75 cents instantly destroys twenty-five cents of value. This is what US companies did back in 2007, and it may be what they are doing in 2018. When the market is overvalued, an investor should want companies to return excess cash in the form of dividends, where a buck is a buck (at least before the tax man visit).

But if that investor were smart, s/he would probably not own the overvalued company in the first place. But that's an entirely different subject. :-)