Stock Repurchases: A Good Idea, Wasted
Back in the 1980s, when I was in business school learning how to spell LBO, our finance professors taught that if a company could not find projects with a positive net present value, based on its cost of capital, then the company should repurchase its shares. A novel thought then, as share repurchases were infrequent.
It’s worth remembering the context. Conglomerates, the darlings of the 1960s, were discredited. Shareholders who wanted to hold shares in multiple businesses could do so directly, they did not need to buy stock in a conglomerate. And the track record for conglomerates, and acquisitions in general, was poor: using excess cash to make acquisitions more frequently helped the CEO’s ego then built shareholder value. (Some things don’t change with time.)
Tax rates also were crucial: dividends were taxed at a higher rate than capital gains. So, our professors taught us: a company, finding itself with more money than attractive internal projects or acquisitions, should distribute that money to its shareholders; and the way to do that most efficiently was to buy back its shares rather than pay dividends.
Was it the power of persuasion? By whatever cause, in 1997, for the first time, the dollar amount of stock buybacks exceeded the amount of dividends paid, and that trend has continued since.
Much like my golf game—a good walk, wasted—share repurchases are a great idea, often misapplied. Why?
The tax argument no longer holds. Most shareholders pay a higher capital gains tax rate than a dividend tax rate, and capital gains tax rates likely are headed up (if only we could legislate an increase in the gains!)
More critically, companies preaching that share repurchases “return money to shareholders” are wrong, or at least only theoretically correct. If a company repurchases its stock, and all shareholders sell at precisely their percentage ownership in the company, then after the repurchase, all shareholders continue to hold the same percentage and all have received the same pro rata distribution of cash.
In practice, of course, some shareholders sell, some hold. Which shareholders get the money? The EX-shareholders, the ones who sell their shares. Imagine how popular stock buybacks would be if corporate executives said that they were done in order to enrich EX-shareholders!
For the great bull market at the end of the 20th century, this distinction did not matter much: stock prices were headed up. So shareholders who sold early—those EXs—received less economic value than those still holding their shares.
Major stock indices are lower now than at the start of the decade. And if stock prices are trending down during the period of a share repurchase, then the EX-shareholders are enriched, not the current shareholders
Leverage and timing are two further problems with stock repurchases as practiced. While companies occasionally borrow money to pay a special dividend, typically dividends are paid out of earnings. If earnings decline, and dividends stop, shareholders are unhappy. But if a company borrows money to do a stock repurchase, then earnings decline, the company can stop the stock repurchases but still owes the debt. Such shareholders also are unhappy, but their unhappiness is leveraged.
Leverage magnifies the effect of transferring wealth to EX-shareholders. Worse, it may prohibit a company from taking advantage of future opportunities because of having used its debt capacity for untimely share repurchases. And in the worst case, the company finds itself conversing with bankruptcy lawyers.
Companies do a poor job of timing their share repurchases. That need not be: as companies buy back their own stock to hold it indefinitely, companies should be able to take advantage of price volatility to buy when Mr. Market sees nothing but negatives and is offering the shares cheap.
In reality, companies tend to buy back shares when times are good and their stock prices high. The better the times, the higher the price, the more shares repurchased. Then when the economy or their company hits a bump, the stock price falls, and the company decides to stop the share repurchases to conserve cash. That’s a recipe to buy on the highs and hold on the lows—or, if the company later needs to raise capital, sell on the lows.
What’s a Board of Directors to do?
1. Returning capital to shareholders is a great practice, and companies should retain the discipline of evaluating the NPV of internal projects or acquisitions, comparing this to returning capital to shareholders.
2. When money is to be returned, prefer dividends, particularly when the economy is strong and the company’s stock price high.
3. Don’t use repurchases as a daily can of Red Bull for the stock price. Use share repurchases infrequently, when Mr. Market prices your company’s stock as inexpensive relative to its long term prospects. That likely will be when the economy is soft, and fear trumps greed.
4. Evaluate your executive team’s performing in executive stock repurchases. This is easily done: calculate the amount of shares repurchased over the last three years and the total dollar cost. Compare that to the cost of shares if purchased today. The gain or loss in shareholder value may be surprisingly large!
October 21, 2008
Posted by: Boyink on Oct 27, 08 | 11:49 am | Profile