Share buybacks, an introduction

March 06, 2019

You may have heard that U.S. corporations used much of their tax cut money in 2018 to buy back shares.

As that news rolled out, it was immediately politicized. But whatever your position, the action by management teams was predictable. Put yourself in the shoes of a manager of a large American corporation. You get a windfall from the government in the form of a lower tax rate. Your competitors get a similar windfall. Your shareholders know you received it, and because, as a manager of a public corporation, you live and die by your stock price, the quickest thing to do is to buy your own shares back in the open market. With everyone else buying back shares, pressure increases dramatically to do so.

What's going on here?

When a company buys back shares, it goes to the open market, pays for the shares, and retires them to its own treasury. This has the effect of reducing the number of shares, or slices, of the business. If business performance stays the same, and the number of shares declines by 50%, the earnings per share double, and the stock price, in theory, should double as well.

Why do this fancy-pants share buyback stuff when you could just pay out the earnings in dividends? It used to be more tax-efficient to increase the value of shares and then an investor would sell the shares and receive the capital gains tax rate, but the introduction of qualified tax rates for dividends narrowed this gap.

Not that I make the decision, but I prefer dividends to share buybacks, even though in some cases they are less tax efficient. Dividends are clear and people understand them. Clarity and simplicity matter. People do not understand the backhanded trade that goes on with corporate management and share buybacks: sure, buybacks may be happening, but boards of directors are issuing shares at a frenzied pace primarily to management teams and upper-level employees, thus diluting the shareholders. In other words, one hand is buying back, and the other hand is issuing.

Let's look at the legal disclosure in Apple's 2012 annual report: "The repurchase program is expected to be executed over a three-year period with the primary objective of neutralizing the impact of dilution from future employee equity grants and employee stock purchase programs." And from Hewlett-Packard, from years 2006 to 2011: "HP repurchased shares in the fourth quarter of fiscal 2006 [2011] under an ongoing program to manage the dilution created by shares issued under employee stock plans." (1)

Finally, share buybacks assume management has some insight into markets and the ability to time the purchase of their own stock. McKinsey & Company showed that most companies cannot time these purchases well. More importantly in their study, linked below (2), is the argument that share buybacks may not create long-term value. Forbes points out a counter-study by MSCI that leads to the opposite conclusion (3). But that's a different newsletter.

(1) The Value of Share Buybacks, Magnus Pedersen

(2) How share repurchases boost earnings without improving returns - McKinsey & Co

(3) Why the TCJA Led to Buybacks - Forbes

Dan Cunningham