Dear management teams and board members,
We want to address a problem that has gone largely unacknowledged in capital markets conversations: The widespread prevalence of buybacks and their potential to erode ongoing shareholder value. It is almost universally accepted that buybacks are a way of “returning value to shareholders.” While intelligent buyback strategies do indeed benefit ongoing shareholders, poor buyback strategies are far more common and have the opposite effect. They destroy shareholder value. This predicament arises because most management teams lack a systematic approach to assess the true value of their company’s stock. Surveys conducted spanning the last four decades reveal that 55-80 percent of CFOs believe their company’s stock is undervalued, while 20-45 percent consider it fairly valued, with only a fraction acknowledging overvaluation.1 Consequently, regardless of how high their company’s stock price soars, it is always deemed an appropriate time for a buyback. Ironically, when stock prices experience significant declines and a greater percentage of stocks trade below fair value—a favorable environment for considering buybacks—such initiatives swiftly dwindle. This epitomizes the “buy high, sell low” behavior that characterizes contemporary buyback practices.
In this discussion, we will explore the following key points:
- The Evolution of Buybacks and Their Primary Drivers:
We will examine the historical evolution of buybacks and delve into the three primary reasons why management teams and boards heavily utilize them as a capital allocation tool. By understanding the underlying motivations for buybacks, we can gain insight into their widespread adoption in corporate practices.
- The Detrimental Impact of Poor Buyback Strategies on Ongoing Shareholder Value:
Through a clear and straightforward hypothetical example, we will mathematically demonstrate how poorly executed buyback strategies can erode value for ongoing shareholders. We highlight the specific ways in which these strategies fail to deliver the intended benefits and, instead, result in a negative impact on shareholder returns.
- Exploring Alternative Strategies for Delivering Shareholder Value and Effective Investor Messaging:
We will explore alternative strategies beyond buybacks that have the potential to enhance shareholder value. Additionally, we will discuss how management teams can effectively communicate these alternative approaches to investors. By examining the benefits of these alternative strategies and understanding the importance of clear messaging, we can pave the way for a more comprehensive and value-driven approach to capital allocation.
Popularity of Buybacks
Once perceived as a form of market manipulation, stock buybacks were prohibited in the 1930s. However, a significant shift occurred in their regulatory status when the SEC introduced Rule 10B-18 in 1982 during the Reagan administration. This rule established a Safe Harbor provision, enabling firms to repurchase shares within specific guidelines. This change played a vital role in combating corporate raiders and addressing principle-agent problems associated with excess cash on balance sheets. As proponents of this change, we recognize it as a highly positive development in capital markets, as it enables management to employ buybacks as a means of addressing such issues.
Since their legalization, buybacks have gained immense popularity and have surpassed dividends as the preferred form of corporate payouts. In fact, buybacks reached a remarkable milestone, a record-breaking figure of over 1.1 trillion dollars in 2022.2 Notably, unlike dividends that are more large cap biased, this phenomenon is observed across both large and small-cap companies, with approximately 90% of large caps and 80% of small caps participating in buyback activities in recent years.2
As previously stated, the belief that buybacks are a means of returning value to shareholders is universally accepted. Robert Reich, a former labor secretary and my former economics professor, captures the basis of this belief by stating,3 “Buybacks…force stock prices above their natural level. With fewer shares in circulation, each remaining share is worth more.” This line of thinking, coupled with the substantial volume of buybacks being executed, has drawn political attention. The natural leap is to conclude that buybacks are enriching shareholders and executives at the expense of hard-working Americans. Curiously, Reich’s line of thinking overlooks the cost associated with this concentration of shares. While ongoing shareholders now possess a higher portion of earnings for each share they own, the company’s cash/equity has been exchanged for this privilege. In the subsequent example presented below, we will clearly demonstrate why the notion that buybacks unconditionally ‘return shareholder value’ warrants questioning and qualification. However, before delving into this core discussion, it is essential to momentarily detach from the political noise and provide an overarching understanding of why buybacks have become so prevalent in today’s corporate landscape.
The Three Primary Reasons Companies do Buybacks Today
Reason 1: A flexible approach to satisfy shareholders and mitigate activist scrutiny
Companies with surplus cash often face pressure from shareholders to allocate capital effectively. While dividends have long been considered a reliable method of returning capital, they possess inherent inflexibility. If a company were to reverse its stance and announce a dividend cut, it would be met with a significant stock price decline. Companies experiencing dividend cuts or eliminations face an average stock price drop of approximately 7% upon announcement.4 Conversely, there is no such market punishment when companies refrain from announcing buybacks or even fail to follow through on previously announced buybacks. Buybacks, in comparison, carry less price risk and afford management greater discretion, making them a flexible approach to appease shareholders and address the issue of excess cash, which could otherwise attract activist attention.
Reason 2: To immunize dilution from Stock-Based Compensation (SBC)
More and more Stock-Based Compensation (SBC), which inherently carries dilutive effects, is increasingly recognized as a means to compensate executives and employees. SBC has experienced significant growth as a percentage of revenue over the years, with factors such as the expanding presence of the technology sector and a decline in cash-flowing companies being cited as contributors.5
Various forms of SBC, including Employee Stock Purchase Plans (ESPPs), Performance Stock Units (PSUs), Stock Options, Employee Stock Ownership Plans (ESOPs), Restricted Stock, and Restricted Stock Units (RSUs), serve as useful tools for retaining, motivating, and compensating executives and employees. Regardless of the underlying causes, the consistent issuance of SBC and its resulting dilution are undeniable. For certain management teams, particularly those in the technology sector where SBC can account for approximately 4-5% of revenue,5 immunizing dilution resulting from SBC issuance may serve as the sole motivation for engaging in buybacks. In other words, management strategically utilizes buybacks not to boost EPS, but to ensure that EPS does not decline as a result of SBC.
In 2022, U.S. publicly traded companies completed over 1.1 trillion dollars in buybacks and SBC exceeded 287 billion dollars, for a 4 to 1 ratio.2,5 While SBC does not fully explain buyback behavior, mitigating the dilutive impact of SBC while supporting EPS holds significant importance for companies.
Reason 3: The Institutional Imperative
The average tenure of a CEO in a public company is relatively short, with the median tenure observed at approximately five years.6 Executives have dedicated their entire careers to reach their current positions, and job security understandably ranks high on their list of priorities. Warren Buffett introduced the concept of “The Institutional Imperative” in his 1989 letter to shareholders. He emphasized that corporate managers often feel compelled to emulate the actions of their industry counterparts or competitors without first conducting a thorough analysis. A notable example of this phenomenon is the conglomerate boom of the 1960s.
During this time, large American firms believed they possessed postwar scientific methods that could amalgamate unrelated businesses and, through the magic of diversification, create a new type of company immune to cyclical downturns and competitive pressures. Investors celebrated this notion, believing that earnings could continue to rise indefinitely. Between 1965 and 1969, American businesses witnessed the emergence of the Third Merger Wave, with approximately 90% of Fortune 500 companies operating in substantially different lines of business.7 However, by the end of the decade, triggered by the downfall of Litton Industries, the conglomerate trend quickly unraveled. It became evident that disorganization, inefficiency, and a lack of focus far outweighed any benefits derived from diversification.
We highlight this historical episode to draw parallels with the present-day tendencies exhibited by management teams when employing buybacks. Following the herd often appears to be the safest strategy for management teams seeking shareholder approval and job security. Given the continuous surge in buyback activity, year after year, it becomes challenging to criticize the decision to repurchase shares as a misguided one.
How poorly executed buybacks destroy ongoing shareholder value
Consider the scenario of Stock XYZ, which begins the calendar year trading at a price that is 50% above its fair value. Throughout the year, the company’s fundamentals and prospects remain relatively unchanged, leading to a correction in the stock price to its fair value by the end of the year.
On January 1, 202X, Company XYZ’s stock price is $15 per share, while its fair value is assessed to be $10 per share. The company holds $45 million in cash on its balance sheet, carries no debt, and has a market capitalization of $150 million. The intrinsic value of the firm is calculated as $10 per share multiplied by the 10 million shares outstanding, amounting to $100 million.
Let’s focus on Bob the Investor, who decides to become a long-term shareholder of XYZ by purchasing 1 share at $15 per share on January 1, 202X. At this time, the company announces an aggressive buyback strategy, intending to utilize its entire $45 million cash balance for open-market purchases at the prevailing market price of $15 per share. Consequently, the buyback reduces the outstanding shares by 30% (3 million shares, obtained by dividing $45 million by $15 per share). This move implies that the company has employed 45% of its intrinsic value to repurchase these 3 million shares, leaving management and investors delighted with the perceived “return of value to shareholders.”
However, let’s assess how this strategy ultimately affected Bob’s investment by the end of the year. On December 31, 202X, XYZ’s intrinsic value stands at 55% of its value at the start of the year, amounting to $55 million. The current price now aligns with fair value and with 7 million outstanding shares, this results in a share price of $7.86 (obtained by dividing $55 million by 7 million shares). Bob’s total return on his investment is calculated as ($7.86 / $15) – 1, which yields a disappointing -48%.
To gain perspective, let’s examine Bob’s potential return if management had not pursued the buyback. In this scenario, XYZ would still possess the cash on its balance sheet, and the stock price would have started the year at $15, eventually repricing to the fair value of $10 by year-end, resulting in a return of -33%. Although not ideal, it outperforms the -48% return caused by the company’s poor buyback execution by a differential of 15%. This example serves to highlight how a company’s misjudgment in employing buybacks can detrimentally impact ongoing shareholders.
While this hypothetical case may appear extreme, similar instances are encountered regularly. Many companies proudly announce that buybacks have reduced their shares outstanding by 10-20% or even as high as 60% over 3-5 year periods. Regrettably, such actions often involve significant amounts of cash being expended to retire overvalued shares, adversely affecting both the company and its ongoing shareholders.
Timing of Buybacks
The timing of buybacks is an essential factor to consider when assessing their effectiveness and impact on shareholder value. It is often observed that companies tend to conduct a significant portion of their buyback activities during periods of market prosperity, while greatly limiting or restricting such activities during more challenging market conditions (see figure below). This behavior contradicts the conventional market wisdom of “buying low and selling high”.2
Acknowledging the practical purpose of this discussion, it is important to recognize the procyclical reality of buybacks. Companies tend to have more surplus cash during favorable economic conditions, and the competition for talent is higher when unemployment is low, leading to increased SBC during these periods. Consequently, some level of procyclicality in buyback strategies can be justified to mitigate dilution from SBC. However, caution should be exercised when buybacks exceed the scope of immunization. Engaging in buybacks beyond this purpose raises the risk of management purchasing shares while the stock is overvalued.
The optimal use of buybacks would involve counter-cyclical deployment. Companies could utilize buybacks as a means to address SBC dilution during market upswings and as a way to return value to shareholders during market downturns. By aligning buybacks with market cycles in this manner, companies can maximize the benefits for ongoing shareholders and avoid the pitfalls of purchasing overvalued shares.
Alternate Strategies & Special Dividends
Time to re-assess the basis for share repurchases with your treasury department
Now is an opportune time to revisit the basis for repurchasing shares with your treasury department. The Inflation Reduction Act of 2022 has imposed 1% excise tax on net buybacks and the SEC has adopted new rules that mandate significant new disclosures. Although these regulations may not significantly impact corporate behavior today, they pave the way for potential future changes. Management teams with a comprehensive strategy for corporate payout policies will be better prepared to navigate such developments.
Large Special Dividends: An underused capital allocation tool
Special dividends, despite being utilized only by a handful of firms, present an effective means of guaranteeing a return of capital to shareholders during business cycle upswings, without binding the company to future regular dividend commitments. Special dividends may be viewed unfavorably compared to buybacks, as the latter can be implemented gradually over an extended period, whereas special dividends are typically paid out only once a year. However, this need not be an obstacle. For instance, a company that has reduced its shares outstanding by 15% over two years could have instead considered two substantial special dividend payments. To us, special dividends indicate a more shareholder-focused management team willing to stand out from the crowd.
A simple strategy is better than no strategy
We encourage management to have internal methods for assessing the fair value of their firm. As a starting point for the conversation, we offer a simple trendline strategy: if your stock is trading well above the trendline, use buybacks minimally, primarily to immunize SBC dilution. Instead, allocate excess cash earmarked for returning capital to investors in the form of a special dividend. Conversely, if the stock is trading well below the trendline, utilize the excess cash for share repurchases.
We understand that management teams are unlikely to explicitly state to investors, “We believe our stock is at risk of being overvalued, so we are suspending buybacks.” Instead, effective messaging should convey that corporate payout actions are part of a broader strategy. For example: “While we consider our stock to be currently undervalued, we approach buybacks in a more counter-cyclical manner compared to our competitors. The return on investment from buybacks is amplified during market downturns. During stable or rising markets, we employ buybacks minimally and instead explore alternative ways to return capital to shareholders, primarily through special dividends. We believe this approach will generate the highest ROI for our shareholders, and we take pride in the deliberate design of our corporate payout policy.” While some investors conditioned to believe that buybacks are always the optimal capital allocation method may have further inquiries, astute investors will appreciate management’s sophisticated approach of combining buybacks and special dividends. We believe that management teams framing their buyback policies in counter-cyclical terms will receive favorable recognition from investors.
The widely held belief among investors that buybacks are always beneficial and effectively return capital to ongoing shareholders is the central issue at hand. We have provided substantial evidence to demonstrate why this belief is not always true. The prevailing narrative often leads management teams and boards to overlook the critical task of aligning buyback policies with rational price considerations. It is our sincere hope that more management teams can influence investor sentiment by effectively communicating an enhanced perspective on this commonly misused form of capital allocation.
Ultimately, the goal is to ensure that management teams exercise prudence and discipline when deploying capital through buybacks, taking into account the fair value of company shares and the long-term interests of ongoing shareholders. Through transparent communication and a comprehensive approach to capital allocation, companies can redefine the narrative around buybacks and promote more effective and value-enhancing strategies.
1John R. Graham, “Presidential Address: Corporate Finance and Reality,” Journal of Finance.
2Liyu Zeng, S&P Dow Jones Indices, “Examining Share Repurchases and the S&P Buyback Indices in the U.S. Market.”
3Robert Reich, “The Buyback Boondoggle is Beggaring America.”
4Wolfgang Bessler, Tom Nohel, “The stock-market reaction to dividend cuts and omissions by commercial banks,” Journal of Banking & Finance.
5Michael J. Mauboussin, Morgan Stanley & Counterpoint Global Insights, “Stock Based Compensation, Unpacking the Issues.”
6PwC’s Strategy & Global Study. “CEO turnover at record high; successors following long serving CEOs struggling.”
7Sean Thomas Delehanty, “The Shareholder Value Revolution.”
INVESTMENT DISCLAIMERS & INVESTMENT RISKS
Past performance is not necessarily indicative of future results. All investments carry significant risk, and it’s important to note that we are not in the business of providing investment advice. All investment decisions of an individual remain the specific responsibility of that individual. There is no guarantee that our research, analysis, and forward-looking price targets will result in profits or that they will not result in a full loss or losses. All investors are advised to fully understand all risks associated with any kind of investing they choose to do.