Why The ‘Buyback Bonanza’ Isn’t A Bad Thing -- It’s Actually A Good Thing

Companies in the S&P 500 are on pace to break the record for share repurchases in 2019, according to Goldman Sachs in this CNBC article. The level of buybacks to free cash flow hit 104 percent for the 12 months ending in Q1 of 2019 and Goldman projects buybacks to total $940 billion. Because this is silly season and a new election cycle, there has been negative attribution regarding share buybacks. But this doubt is unfounded. Instead of buybacks enabling uncertainty, this action should exude confidence to shareholders of these companies and the market at large, and in most cases, is the most efficient use of capital.

In today’s current environment, companies that have excess capital that can’t be responsibly deployed are penalized with historically low interest rates. Therefore, the cost to hold it is very expensive, relatively. If they increase dividends to distribute excess capital, it’s double taxed and less efficient. Further, if it’s not a one-time dividend, the company is now obligated to an accelerated dividend schedule in perpetuity. The principle benefit of buying back stock is that companies are not only investing in themselves which reduces risk – they should know their own company – but non-selling shareholders that retain their stake own more of the company and their value should be enhanced. Just look at Warren Buffet and American Express. Buffet’s history with AMEX goes back to the salad oil scandal of the 1960s. In 1991, Berkshire paid $300 million in to the company in exchange for preferred stock, and by 1995 the investment was converted to common stock and Buffet’s company Berkshire owned around 10 percent of AMEX. And since then, Berkshire has just stayed still. Five years ago in his 2013 annual letter to shareholders Berkshire had 14.2 percent ownership in AMEX, and in his 2018 letter, that number had jumped to 17.9 percent. Berkshire has benefited from AMEX’s increased share buyback program, with an uptick in value and a 30 percent rise of ownership in the company. And that’s the whole point. They can’t force you to sell them your shares.

Opponents of share buybacks are saying to corporate managers that they should invest further in the business or avoid buybacks by acquiring other companies. Both of those approaches are much riskier. They’re asking corporate managers to take those risks when they only get one upside – if they destroy value then they lose their job. The downside is shared exclusively by the shareholders. Buying a company comes with inherent risk and most transactions destroy rather than create value over a five-year time horizon. The path needs to be extremely well thought out and deliberate. It’s true that companies are increasingly using debt to fund these share buybacks – but it’s not different than borrowing money to buy a company – something IBM just did in its historical $34 billion acquisition of Red Hat. IBM is paying a ‘rich valuation’ for Red Hat, paying $190 a share in cash, which will cause them to discontinue share buybacks and was dilutive to current shareholders based on purchase price. In the short-term, it’s a lose-lose situation. Lastly, it’s still not clear whether integration with Red Hat will be successful – which adds another component of risk.

The argument against buy backs is corporate managers should invest in their people and businesses, and God knows Capex. Today they are incentivized to spend billions of dollars of excess capital on new Capex, new products and services, or M&A investments outside of the company. They are opting not to do this because the returns don’t justify the risk or return – which is exactly how it should be. This shows that corporate managers can be thoughtful stewards of capital. It’s been proven time and time again when companies adopt wasteful internal investment or M&A strategies that did not make economic sense that workers, customers, the company and shareholders suffered. 

***Disclosure: This article is intended for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial product or service.