Chicago Boyz

                 
 
 
What Are Chicago Boyz Readers Reading?
 

 
  •   Enter your email to be notified of new posts:
    Loading
  •   Problem? Question?
  •   Contact Authors:

  • Blog Posts (RSS 2.0)
  • Blog Posts (Atom 0.3)
  • Incoming Links
  • Recent Comments

    • Loading...
  • Authors

  • Notable Discussions

  • Recent Posts

  • Blogroll

  • Categories

  • Archives

  • Business Week Article on Stock Buybacks

    Posted by Carl from Chicago on August 16th, 2009 (All posts by )


    A recent Business Week article titled “The Buyback Boondoggle” discusses stock repurchases.

    As the unemployment rate hovers near 10%, the economic debate is focused on how the government should aid recovery… but it’s business’ task to get the economy back on track – by investing in innovation and job creation. And if the recent past is any guide, corporations may stall the recovery by investing instead in something else – stock buybacks.

    This article is an example of poor journalism and populist reasoning right from the start. You can see the writer’s view on business – that its purpose is somehow to create jobs – and that this should be the main goal of a business. Which, frankly, is a terrible assumption.

    Businesses are created to make money. Businesses are (usually) run by smart people who want to invest their equity capital (raised from the stock market) in the place that will earn them the most money, and if they have a lot of equity capital outstanding (in the form of stock proceeds and retained earnings) they have to put this money to work on new projects that are at least as profitable as their current portfolio, or they are decreasing their company’s profitability, which is severely disliked by investors.

    And the United States nowadays is a poor place for new investment. Want to know which country in the developed world has the least friendly tax outlook? The good ol’ USA. Per that highly recommended site “The Tax Foundation

    Currently, the average combined federal and state corporate tax rate in the U.S. is 39.3 percent, second among OECD countries to Japan’s combined rate of 39.5 percent… Many states impose state corporate income taxes at rates above the national average of 6.6 percent. Iowa, for example, imposes the highest corporate tax rate of 12 percent, followed by Pennsylvania’s 9.99 percent rate and Minnesota’s 9.8 percent rate. When added to the federal rate, these states tax their businesses at rates far in excess of all other OECD countries.

    The US also has a surplus of lawyers and a highly litigious culture that requires businesses to spend an inordinate amount of time preparing for lawsuits of every sort. And if you want to build something, such as a manufacturing plant… you must be kidding, right? The environmentalists and regulators will tear you to shreds, with protests, forms, and a never-ending stream of bad publicity. And if you have unions, or are in a state loaded with unions (such as the Midwest, sadly enough) you have a militant work force demanding gold plated benefit plans and happy to walk out and crush your operations at a moment’s notice.

    It is true that compared to dictatorships and countries without the rule of law there are many advantages of investing in the United States, but this isn’t an absolute comparison of the US vs. one of those countries, but a relative comparison given that a US corporation could choose to locate facilities anywhere around the world. And more insidiously, a US corporation wouldn’t even raise capital here to build an overseas business – they would raise that money from the start in a tax haven or in a private corporation with a complex legal structure that wouldn’t be in the USA.

    Nowhere in this article does the author discuss how to make America’s business climate more favorable to businesses, which would encourage them to invest more in the United States and start projects that would enable innovation and job creation. Our poor business climate is why businesses won’t invest more here, and that is the issue that the author needs to tackle directly, not through jawboning and demanding that regulators and politicians review business practices, which will basically just yield us “more of the same”.

    Regardless of the provenance of this argument, I too agree that stock buy backs are a bad idea. A stock repurchase occurs when a company goes out and buys its own stock back from the market (there are many ways of doing this) which reduces the number of shares outstanding. Since companies are widely judged on a metric called “Earnings Per Share” or EPS, the fewer shares that you have outstanding, the better your earnings look.

    A better idea would be to return these funds to shareholders through dividends. Dividends receive favorable tax treatment, although maybe not as favorable as stock buy backs, but more importantly they give this money directly to the share holders so that the share holders can determine what they want to do with it themselves, rather than essentially leveraging their existing investment in a corporation. Corporations do not like to raise dividends because it changes the expectations of share holders – once share holders receive dividends, they generally get angry and punish the stock price if those dividends are cut. Dividend cuts are public events, understandable by all share holders, while starting and stopping a corporate buy back is an opaque process generally not understood by everyone except for a few stock analysts.

    Rather than focusing solely on EPS, companies could tout their stock price, future growth prospects, and dividend yield as a measure of why share holders should consider them a sound steward of the funds that they have been entrusted with. A strong payout sends a message that the business is committed to profitable operations and fiscal discipline, today and in the future.

    Cross posted at LITGM

     

    7 Responses to “Business Week Article on Stock Buybacks”

    1. Simon Kenton Says:

      Buybacks are irritating but they can result in marginally positive stock-price changes. The real dead canary is a reverse split. Or a request from management to do a reverse split. I’ve never seen it work out well; I treat it as an immediate sell signal.

      It used to be that a corporation retaining cash with no particular prospects of using it well could look forward to being taken over. It was an arcane form of schadenfreude to respond to management’s appeals to retain them with a note saying, “You kept my money and did nothing effective with it. Now you are going to be gone.” I wish we had the chance to say something similar to politicians.

    2. David Foster Says:

      Companies doing stock buyback don’t have a very good record as market timers–they have very often bought their own stock when it was way overvalued, rather than when it was cheap. Which leads me to cynically believe that most companies actually won’t do buybacks at the current level but will wait until they can pay more for it.

      But what the BW writer fails to do is to seriously think about the flow of money. If a company buys back stock, then the cash they were holding doesn’t disappear–it goes to the former shareholders…who, in turn, may well invest it elsewhere.

      The company that has a lot of cash on its balance sheet at a given moment is not necessarily that company that has the most compelling investment opportunities at that same moment. There is no evidence that capital investment decisions *within* corporations, done by corporate management, are more efficient than capital allocation decisions *across* corporations, done by investors. You would think that decisions of the first type *would* be more efficient, given the benefits of knowledge and focus, but it doesn’t seem to work out that way.

    3. Carl from Chicago Says:

      I wouldn’t say that companies that buy back stock return the cash to shareholders. They may implicitly push up the stock price (or keep it at a higher level) but they don’t actually put cash in shareholder hands – only dividends do that, which is why I prefer them.

      But agreed on capital allocation.

      One of the biggest reasons that companies do stock buy backs is because if they don’t all of the options that they issue and that vest would end up diluting existing shareholders. They are buying back stock on the open market to “run in place” net against their options being exercised.

      Of course that isn’t a problem now because the options are generally worthless and the companies don’t have the cash to buy back stock, either.

      The writer didn’t talk about that, either.

      Agreed that companies aren’t great market timers but if you view it as a race to keep up with options being exercised it makes more sense.

    4. David Foster Says:

      Share buybacks certainly put cash in shareholder hands. If a company has a buyback offer and I sell them stock I currently hold, then the cash is transferred from them to me, and I can do something else with the money.

      Buybacks, though, only transfer cash to those shareholders who sell stock as part of the buyback, unlike dividends which transfer cash to *all* shareholders.

    5. Carl from Chicago Says:

      Rarely are buybacks of the type you describe. For Home Depot, they had a corporate event, and offered to tender my shares at a set price. In those instances, certainly, you have the opportunity to sell your shares back to them and receive the cash. If you retain your shares, you implicitly benefit through the higher EPS that will come from a smaller share base.

      But the vast majority of corporate share buy back programs, including virtually all of the ones referred to in the article, occur when the corporation goes out into the market and buys up shares in various ways, maybe in the open market, or maybe through private placements, or even dark pools. In those cases usually the corporation intends to make as little an impact as possible in the overall market price for shares.

      This is what I was speaking of when I said that share buybacks rarely put cash in shareholder hands, either directly or indirectly, but they may impact the price.

    6. david foster Says:

      CfromC…from a macro point of view, it doesn’t really matter how they do it. No matter how they (the company) get the shares, they pay for them, and this puts money into the hands of certain investors. Some of these investors will reinvest the money elsewhere, perhaps in a company that will make better use of it.

    7. skh.pcola Says:

      “Many states impose state corporate income taxes at rates above the national average of 6.6 percent.”

      Wow. I didn’t look at the distribution and the guy didn’t say “median,” but the assumption is implicit that “many states” would be above the average. You nailed it, Carl…poor journalism, for sure.