The Trump Tax Act that was passed by Congress and signed into law by the president in January of 2018 gave President Trump political capital, a bargaining chip in his dealings with corporate America. In exchange for the tax cuts that took the corporate rate from 35% to 21%, US businesses had to somehow return the favor. Corporations were told they could do that by repatriating both their offshore cash, and their offshore labor; in other words, they were told to bring cash and jobs held overseas back to the United States. The corporations would not be fined or hit with back-taxes on that cash; actually, quite the opposite. The repatriated off-shore cash would be taxed at a one-time reduced rate. This would mean a one time influx of much needed tax revenue for the US Treasury, and more jobs for US workers. Sounds simple enough, right? The only thing we know for sure right now is that the tax cuts are working. The US stock market, and US GDP, are booming. The corporate tax cuts have been adrenaline for corporate earning expectations.
With that said, not everyone is happy. The Wall Street Journal reports that despite the tax cuts, corporations, the real beneficiaries, are doing little to nothing to invest their gains. Capital expenditures and other business investment is unchanged. Where did all that tax cut money go? The answer is, largely toward share buybacks. Share buybacks are when a company buys back its shares on the open market. When a company buys its own shares, it reduces the “float”, or the outstanding number of shares.
Share buybacks is what a company would do if it wanted to take itself private; it would just do it in one big swoop. When Elon Musk recently announced he wanted to take Tesla private, his intention was to buy as many shares as possible from the public, with money raised from investors. Those investors would be the new shareholders in the company; the difference would be the shares of the company would be concentrated in a few hands, as opposed to spread out amongst the public. The only way a company can go private is if a majority of shareholders agree on the price per share of the deal. Shareholders are usually well compensated in a take private deal.
When a company performs a share repurchase, it also means that it’s “earnings per share”, or EPS, goes up, even if earnings stay the same. This is because decreasing the number of shares, the denominator, increases the total value (EPS). A company can either increase the numerator (earnings in $), or decrease the denominator (shares outstanding, or float), and get the same result. Because it so hard to increase earnings, especially in a mature, competitive economy like the US, many companies are performing share buybacks, paying in cash, but sometimes paying in credit (more on that later).
Buying back shares and decreasing the float is an easy way to increase EPS. Investors in public companies measure the performance of C-suite executives by using the EPS metric. These executives are therefore incentivized to perform share buybacks. Bonus clauses are triggered by EPS numbers; if a CEO delivers or beats a target EPS, he can fatten his wallet substantially. The path of least resistance toward higher EPS becomes the share repurchase program; increasing earnings is too hard when short-term gains are the focus of large investors. Warren Buffet and Jamie Dimon warn this mentality is harming the economy by reducing the incentive to reinvest earnings into the business. Most company executives either can’t bear the risk, or don’t have the innovation, to increase the numerator.
IN-DEPTH ON SHARE BUYBACKS
An article in the Atlantic dives deep into the issue of share buybacks and their effect on the economy. Let’s dive into this article with some further analysis of our own.
First, is there evidence that share buybacks increase when interest rates rise? In theory, this would make sense. When interest rates go up, financial assets, including company shares, become less attractive, especially if companies do not anticipate growth keeping up with rising rates. When rates go up, it’s easier to simply buy the risk-free yield, in the form of a US Treasury bond, and earn a risk-free return. Remember, the risk-free yield, or rate, is the rate of return on US treasury debt. Ultimately, the risk-free rate is different for different debt maturities, or loan term. For example, the rate on a 30 year mortgage today is 4.625%, while the rate on a 15 year mortgage is 4.375%. The 15 year rate is slightly lower because investors demand more return to lock up their money for a longer duration, as opposed to a shorter duration. Another example would be CD (Certificate of Deposit) rates. A 3 year CD yields 3%, while a 1 year CD yields 2.5%. An investor in CD’s would demand a higher return to lock up his/her money for 3 years, instead of just 1 year. On a side note, notice that the difference in yield between the 15 year and 30 year mortgage, and the 3 year and 1 year CD, is very small. This is because the yield curve, or difference in yield between two maturities, is flattening, or decreasing.
When the risk-free return is meaningful, then it makes less sense to buy risky assets, such as stocks. Therefore, when interest rates increase, it would make sense that companies would increase their share buybacks, given the shares may be cheaper. Furthermore, psychologically, people associate a company buying its shares with the shares being cheap; it’s assumed that the company is the best assessor of its own value, and otherwise wouldn’t buy. The cheap theme is therefore reinforced, and adds reason to buy. Second, because a reduced float potentially increases EPS. Rising interest rates make it harder to increase earnings; the share buyback can lift EPS when high interest rates are making it harder to run the business. How well a company performs the share buyback is obviously important. Companies tend to announce share buybacks when they release earnings, but exactly when they conduct purchases goes unannounced. Companies have no obligation to announce the actual dates they are in the market buying. As a result, they don’t. Remember what we said earlier about information in market economies?
The Atlantic gives a definition of share buybacks, and notes something worth mentioning.
“Buybacks occur when a company takes profits, cash reserves, or borrowed money to purchase its own shares on the public markets, a practice barred until the Ronald Reagan administration.”
Of interest is the fact buybacks were illegal until Ronald Reagan legalized them in 1982. Ronald Reagan was president between 1980 and 1988. Remember, this was an awful time in the economic history of the US, with rampant stagflation. By legalizing the share buyback, Reagan legalized price manipulation, which was previously illegal. Also of interest, and certainly cause for concern, is that companies can perform share buybacks on credit. Buying shares on credit, or on margin as is the financial term, increases volatility in markets. The restaurant industry has been especially guilty of buying back shares on credit, as pointed out in the following quote from Deloitte Research:
“The restaurant industry spent 140 percent of its profits on buybacks from 2015 to 2017, meaning that it borrowed or dipped into its cash allowances to purchase the shares.”
Share buybacks with borrowed money may explain the spikes in volatility that occur when stock markets sell off; stock prices going down become deleveraging events that compound volatility. When a company buys back its shares with borrowed money, those shares serve as collateral for the loan. The loan has an interest rate. When interest rates are low, it makes sense to buyback shares on credit; interest on credit is low, and low interest rates drive up asset prices (remember, inverse relationship between rates, and asset prices). It’s a dream come true for the filthy rich because so many things are compounding to drive price higher! When rates start to go up, share buybacks on credit start to make less sense. It’s a matter of opportunity cost: if buying $1 Billion of shares yields a 5% annualized return (stock price appreciation), but credit costs 6% per year in interest, then it does not make sense to buy shares on credit. On the other hand, if interest on credit is only 4% annualized, then it does make sense. Conducting share buybacks with cash is also a matter of opportunity cost: if investing in the business (building factories, hiring workers, R&D) can yield a 6% annualized gains, then business investment makes sense. If not, then share buybacks make sense. And that is the fundamental crisis the US economy faces today: a lack of business investment caused by a lack of ROI (return on investment), and a lack of commitment to long term profitability, productivity, and growth. The US economy has stagnated in that sense. That, after all, is the reason why interest rates are so low in the first place.
An interesting study to perform would be a sector by sector analysis on performance of company stocks that are being bought back. How well are the company’s buying back shares actually doing for their shareholders? Are share buybacks justified by performance, or are they simply adding unnecessary leverage (debt) to the market? It just so happens, McKinsey performed this study, albeit, without a sector split. From The Atlantic:
In an exhaustive financial analysis of buybacks, the consultancy McKinsey found that companies would generally be better off issuing dividends or increasing investment instead. Buybacks also might distort earnings-per-share calculations and other measures of profitability and value.
McKinsey has written several papers on buybacks. You can find them here, here, and here. You can also find a piece here that talks about how to companies actually do a horrible job of timing the market, buying back shares often at peak prices. This would mean share buybacks are contrarian indicators; smart investors should be selling when buybacks are peaking.
“Researchers at Deloitte point out that buybacks and dividends have soared as a share of GDP, whereas investment in equipment and infrastructure has remained unchanged. And new research by Germán Gutiérrez and Thomas Philippon of New York University suggests growing business concentration, a lack of competition, and short-term thinking on the part of investors have all contributed to firms ‘spend[ing] a disproportionate amount of free cash flows buying back their shares,’ fostering an environment of ‘investment-less growth’.”
Investment-less growth is a crisis today; growth is no longer real. It is financially engineered.