Stock buyback are killing the American economy

[Guest Schwab711]

The arguments that investor can decide for themselves with dividends makes no sense.

 

If the stock is undervalued, buybacks are always better

 

If the stock is overvalued, buybacks are bad. But why hold the stock? The fact that the investor is holding an overvalued stock means that he will not invest it somewhere else in a better way. He is holding an overvalued stock after all!

 

I see that a lot on this forum too. If you prefer a company to pay dividends, you should sell the stock right away. Because either you can invest it somewhere else with a better return, or you are holding a overvalued company. This is simply rational, and not some matter of preference like some think.

 

Finally you could argue that the index investor will be hurt by this. But on average you would say an index is unlikely to be very over or under valued? As it balances out, so in that case buybacks aren't that bad? If companies are slightly overvalued, the fact that the investor doesn't pay tax on the dividend makes up for it no? And on average, over time, I would say buybacks are not very likely to take place when stocks are overvalued. Unless there is some systemic bias that makes CEO's buyback overvalued stock, but not undervalued stock.

 

I agree on every point. Especially on the idiotic idea of buying a company because it pays a dividend! Only exception I would say to holding stocks that pay dividends are companies that are fairly valued but are not capable of re-investing 100% of their disposable earnings at sufficient ROIC hurdles. I'm thinking of KO or something similar. Any other reason for paying dividends is inefficient capital allocation.

[tengen]

Could it be that what is good for a company / shareholders is not necessarily good for the economy?

[mcliu]

Isn't the issue here stock buybacks vs. capital expenditures/r&d and not stock buybacks vs. dividends?

[oddballstocks]

The arguments that investor can decide for themselves with dividends makes no sense.

 

If the stock is undervalued, buybacks are always better

 

If the stock is overvalued, buybacks are bad. But why hold the stock? The fact that the investor is holding an overvalued stock means that he will not invest it somewhere else in a better way. He is holding an overvalued stock after all!

 

I see that a lot on this forum too. If you prefer a company to pay dividends, you should sell the stock right away. Because either you can invest it somewhere else with a better return, or you are holding a overvalued company. This is simply rational, and not some matter of preference like some think.

 

Finally you could argue that the index investor will be hurt by this. But on average you would say an index is unlikely to be very over or under valued? As it balances out, so in that case buybacks aren't that bad? If companies are slightly overvalued, the fact that the investor doesn't pay tax on the dividend makes up for it no? And on average, over time, I would say buybacks are not very likely to take place when stocks are overvalued. Unless there is some systemic bias that makes CEO's buyback overvalued stock, but not undervalued stock.

 

I agree on every point. Especially on the idiotic idea of buying a company because it pays a dividend! Only exception I would say to holding stocks that pay dividends are companies that are fairly valued but are not capable of re-investing 100% of their disposable earnings at sufficient ROIC hurdles. I'm thinking of KO or something similar. Any other reason for paying dividends is inefficient capital allocation.

 

I'm going to disagree on dividends.  I like buying cheap companies that pay me (the owner) part of the profits back as dividends each year.  My thesis doesn't usually rest on earnings, sometimes it does, but it's usually assets or acquisition value.  I'm essentially paid to wait for IV to be realized.  I own a number of illiquid stocks that never appreciate, but I get a dividend on them.  I'd rather get a steady dividend for years while waiting for the 'one day' when the stock jumps at once.  This way I get two types of returns, the continuing dividend return plus the eventual appreciation.

 

Dividends are something I'm starting to appreciate as I grow older as well.  Extremely successful investors who have been at this for decades all seem to favor a dividend of some sort.  I believe there's a reason for that.  Even Buffett likes to own companies that pay him dividends.

 

[Liberty]

Could it be that what is good for a company / shareholders is not necessarily good for the economy?

 

I think they're aligned over the long-run and if you look at the whole (ie. shareholders are part of the economy). Might not always appear to be in short run because they might be counter-cyclical and avoid excesses, though. But they also don't go bust and destroy tons of capital doing stuff things that don't even earn cost of capital...

[tengen]

Could it be that what is good for a company / shareholders is not necessarily good for the economy?

I think they're aligned over the long-run and if you look at the whole (ie. shareholders are part of the economy).

 

I hope that you are right but I have a nagging doubt. To draw an analogy with consumers, if enough people decide to postpone spending on "optional" goods, we risk entering a vicious deflationary spiral. If too many companies decide to deploy their cash on stock buybacks instead of investing in expansion, does that not stifle economic growth?

[petec]

Granted, I just skimmed part of that piece, so maybe I'm missing the point (hey, gotta pick how you spend your time...), but just from the premise, I wonder if they would write an article about how "dividends are killing the American economy"?

 

Buybacks are just a return of capital to shareholders, who then can spend it however they want (investing, consuming... all things good for the economy).

 

The difference for me is that buybacks (above IV) destroy value as surely as building and then burning down a factory does, and most managements are notoriously bad at buybacks so I suspect a lot of capital is getting destroyed this way.  Dividends don't destroy value unless the shareholder makes a poor decision.  Clearly a shareholder has better alignment with himself than management does with him.  And the incentives are key here: I think management would be better at buybacks if a) dividends were taxed at the same rate as CGT (there is a powerful incentive to buy back stock and boost share prices when you have a lot of options that can be realised at low rates of CGT) and b) management compensation was based on eps growth + dividends rather than just eps growth or total shareholder return, which provides an incentive to juice the multiple.

 

 

[petec]

Could it be that what is good for a company / shareholders is not necessarily good for the economy?

I think they're aligned over the long-run and if you look at the whole (ie. shareholders are part of the economy).

 

I hope that you are right but I have a nagging doubt. To draw an analogy with consumers, if enough people decide to postpone spending on "optional" goods, we risk entering a vicious deflationary spiral. If too many companies decide to deploy their cash on stock buybacks instead of investing in expansion, does that not stifle economic growth?

 

Yes, it does - though there is another way to look at this, which that if there was less debt and more demand in the world companies might *want* to build factories, rather than be in a position where they have more capital than need for capital.

 

But, it all comes back to incentives.  I have no problem with buybacks when a) there is no better use for capital and b) the stock is below IV.  I just have very serious doubts that that is actually how managements are incentivised.  Why build a factory that will generate value over 30 years when you could juice your stock option value with a buyback today?

[Rabbitisrich]

The author might have missed his own argument by focusing too much on the word "buybacks", and not enough on the economic reasoning. Towards the end, he almost pulls it together by implying(?) that favorable tax treatment encourages higher payout ratios than a tax system that somehow treats buybacks and dividends equally. He doesn't explicitly say it, but he must also believe that these excessive payout ratios are not economically punitive, because something prevents reinvestment to fill those areas left undercapitalized by the payouts.

 

If funds are leaving a given legal shell in the cause of shareholder value maximization, then there must be something more interesting outside of those shells. That could mean exciting events outside of public companies, or really uninteresting happenings inside the shells. Instead of tracking the money, and inferring incentives, the author clumsily slaps a bunch of economic concepts together, and assumes that buybacks are the result of self-enrichment, which is apparently a new thing.

[Rabbitisrich]

Could it be that what is good for a company / shareholders is not necessarily good for the economy?

I think they're aligned over the long-run and if you look at the whole (ie. shareholders are part of the economy).

 

I hope that you are right but I have a nagging doubt. To draw an analogy with consumers, if enough people decide to postpone spending on "optional" goods, we risk entering a vicious deflationary spiral. If too many companies decide to deploy their cash on stock buybacks instead of investing in expansion, does that not stifle economic growth?

 

Yes, it does - though there is another way to look at this, which that if there was less debt and more demand in the world companies might *want* to build factories, rather than be in a position where they have more capital than need for capital.

 

But, it all comes back to incentives.  I have no problem with buybacks when a) there is no better use for capital and b) the stock is below IV.  I just have very serious doubts that that is actually how managements are incentivised.  Why build a factory that will generate value over 30 years when you could juice your stock option value with a buyback today?

 

Instead of thinking in terms of buybacks and dividends, think in terms of payout ratios. And then look at differential tax impacts. For example, a stock might be overvalued relative to the market, but the company might have reinvestment opportunities far below the expected market return. In that case, you might want management to increase the payout. The question of how is, for most people, a tax issue. If the stock is overvalued, then the dividend and buyback receivers are deliberately holding overvalued shares. The only difference is that the dividend receiver closes his tax loan for the year, and receives a deferred tax benefit on the lowered basis of his holdings. In other words, he switches from borrowing from the IRS to lending to the IRS. That can be good or bad, but you can see that it isn't obviously connected to the question of stock valuation.

[ni-co]

I think the big picture here is that the zero interest rate environment makes it very appealing to companies to borrow money at very little cost and buy back their own shares. This is rational behavior because they perceive their own ROI as higher than the interest rate they pay on the debt they use to make the buybacks. Implicitly or explicitly, they are making a few assumptions, though, like cash flows remaining stable or interest rates remaining low.

 

Stock buybacks increase their EPS, thereby making earnings appear to grow. You seem to observe solid earnings growth and increasing profitability – all wonderfully rectifying the high valuations. What you are not seeing by focusing on earnings growth per share is that this growth isn't based on an improving business climate but bought by deteriorating balance sheets (raising debt/equity ratios). IBM is the poster child for this behavior like Stanley Druckenmiller keeps repeating.

 

It's quite obvious that this cannot go on forever. Companies are only able to lever up so much. At this very moment, they are extremely vulnerable to rising interest rates and/or an economic slowdown. Equities as a category are priced to perfection and levered up to the hilt right now. This is becoming an increasingly dangerous situation.

 

Coming back to the article: the title is complete nonsense. Share buybacks are the result of ZIRP and lacking investment (capex) opportunities for the companies because demand is still lacking. I don't think that this can be resolved by deregulation like Druckenmiller seems to think. This will go on for quite some time because we are in the midst of a huge deleveraging process. This means demand from consumers is going to stay low for years to come and companies have only been buying time by levering up to justify their valuations.

[petec]

 

Instead of thinking in terms of buybacks and dividends, think in terms of payout ratios. And then look at differential tax impacts. For example, a stock might be overvalued relative to the market, but the company might have reinvestment opportunities far below the expected market return. In that case, you might want management to increase the payout. The question of how is, for most people, a tax issue. If the stock is overvalued, then the dividend and buyback receivers are deliberately holding overvalued shares. The only difference is that the dividend receiver closes his tax loan for the year, and receives a deferred tax benefit on the lowered basis of his holdings. In other words, he switches from borrowing from the IRS to lending to the IRS. That can be good or bad, but you can see that it isn't obviously connected to the question of stock valuation.

 

I accept the logic but I don't think it's this simple.  When you put my theory of skewed incentives together with Ni-Co's ideas about cheap debt driving buybacks, this is what I think you get:

 

a) I believe tax rates on dividends are much higher than those on capital gains so this isn't just a timing issue, it's a skewed incentive.

 

b) It may be so skewed that management have an incentive to buy back stock even when reinvestment opportunities are actually quite good.  Management have a huge incentive to forgo high tax rates on dividends earned over a long period of time in favour of low tax rates on capital gains made quickly on stock options, juiced in two ways by buybacks funded by cheap debt: first they get more options awarded for eps growth driven by buybacks, and second the stock price is higher with the buyback given the supply/demand dynamics of the stock market. 

 

c) Finally, the economic impact of a buyback has everything to do with the valuation of the stock and its future returns, while the economic value of a dividend has nothing to do with the valuation of the stock.  Management teams in aggregate have a poor record of buying back well, and bad buybacks destroy value.  Dividends can't destroy value.  When raising the payout ratio there is therefore a huge difference, which has nothing to do with tax, between a buyback policy and a dividend policy.  Opportunistic buybacks by value-oriented management teams are different, but they seldom happen.  I would argue that this is at least partly because when stock is cheap, options tend to be out of the money and debt costs may well be high, so the buyback doesn't create a huge, immediate payout for management.

 

 

[Uccmal]

The arguments that investor can decide for themselves with dividends makes no sense.

 

If the stock is undervalued, buybacks are always better

 

If the stock is overvalued, buybacks are bad. But why hold the stock? The fact that the investor is holding an overvalued stock means that he will not invest it somewhere else in a better way. He is holding an overvalued stock after all!

 

I see that a lot on this forum too. If you prefer a company to pay dividends, you should sell the stock right away. Because either you can invest it somewhere else with a better return, or you are holding a overvalued company. This is simply rational, and not some matter of preference like some think.

 

Finally you could argue that the index investor will be hurt by this. But on average you would say an index is unlikely to be very over or under valued? As it balances out, so in that case buybacks aren't that bad? If companies are slightly overvalued, the fact that the investor doesn't pay tax on the dividend makes up for it no? And on average, over time, I would say buybacks are not very likely to take place when stocks are overvalued. Unless there is some systemic bias that makes CEO's buyback overvalued stock, but not undervalued stock.

 

I agree on every point. Especially on the idiotic idea of buying a company because it pays a dividend! Only exception I would say to holding stocks that pay dividends are companies that are fairly valued but are not capable of re-investing 100% of their disposable earnings at sufficient ROIC hurdles. I'm thinking of KO or something similar. Any other reason for paying dividends is inefficient capital allocation.

 

I'm going to disagree on dividends.  I like buying cheap companies that pay me (the owner) part of the profits back as dividends each year.  My thesis doesn't usually rest on earnings, sometimes it does, but it's usually assets or acquisition value.  I'm essentially paid to wait for IV to be realized.  I own a number of illiquid stocks that never appreciate, but I get a dividend on them.  I'd rather get a steady dividend for years while waiting for the 'one day' when the stock jumps at once.  This way I get two types of returns, the continuing dividend return plus the eventual appreciation.

 

Dividends are something I'm starting to appreciate as I grow older as well.  Extremely successful investors who have been at this for decades all seem to favor a dividend of some sort.  I believe there's a reason for that.  Even Buffett likes to own companies that pay him dividends.

 

I concur.  There is tons of empirical data that shows that dividend paying companies grow faster than non- dividend payers.  In fact, in cyclical industries I will not buy a company that doesn't pay a dividend.  There are of course, exceptions to every rule.  Fast growing companies in tech are excused, for awhile. 

 

 

 

[yadayada]

The arguments that investor can decide for themselves with dividends makes no sense.

 

If the stock is undervalued, buybacks are always better

 

If the stock is overvalued, buybacks are bad. But why hold the stock? The fact that the investor is holding an overvalued stock means that he will not invest it somewhere else in a better way. He is holding an overvalued stock after all!

 

I see that a lot on this forum too. If you prefer a company to pay dividends, you should sell the stock right away. Because either you can invest it somewhere else with a better return, or you are holding a overvalued company. This is simply rational, and not some matter of preference like some think.

 

Finally you could argue that the index investor will be hurt by this. But on average you would say an index is unlikely to be very over or under valued? As it balances out, so in that case buybacks aren't that bad? If companies are slightly overvalued, the fact that the investor doesn't pay tax on the dividend makes up for it no? And on average, over time, I would say buybacks are not very likely to take place when stocks are overvalued. Unless there is some systemic bias that makes CEO's buyback overvalued stock, but not undervalued stock.

 

I agree on every point. Especially on the idiotic idea of buying a company because it pays a dividend! Only exception I would say to holding stocks that pay dividends are companies that are fairly valued but are not capable of re-investing 100% of their disposable earnings at sufficient ROIC hurdles. I'm thinking of KO or something similar. Any other reason for paying dividends is inefficient capital allocation.

 

I'm going to disagree on dividends.  I like buying cheap companies that pay me (the owner) part of the profits back as dividends each year.  My thesis doesn't usually rest on earnings, sometimes it does, but it's usually assets or acquisition value.  I'm essentially paid to wait for IV to be realized.  I own a number of illiquid stocks that never appreciate, but I get a dividend on them.  I'd rather get a steady dividend for years while waiting for the 'one day' when the stock jumps at once.  This way I get two types of returns, the continuing dividend return plus the eventual appreciation.

 

Dividends are something I'm starting to appreciate as I grow older as well.  Extremely successful investors who have been at this for decades all seem to favor a dividend of some sort.  I believe there's a reason for that.  Even Buffett likes to own companies that pay him dividends.

 

This does not make sense either. Let's say you buy a company with 10m$ in liquid assets and no debt. and 1.25m$ of FCF. Market values them at 10m$. They could buy back roughly 25% of their stock. Lets say they have 10 million shares at 1$ per share. They make 1.25m$ a year. If they reduce share count by 25%, you now have 7.5m shares at 1$ per share. Let's say that half of the buybacks were done with cash that was already on the balance sheet, so assets are reduced by 1.25m$.

 

If you think business is worth 12.5m$ (10x FCF) and 8.75m$ of remaining assets a year later, shares are now worth 21m$/7.5m = 2.8$.

 

But if they would have paid a dividend of 2.5m$ (half of which was their FCF and other half was from some of the cash on balance sheet), you get 8.75m$ of assets and 12.5m$ (assuming again you value the business at 10x FCF), is 21m$ over 10m shares is 2.1$ per share. Plus the 25 cents in dividends. So 2.35$ per share.

 

So let's say you got lucky, and apreciation happened in 1 year. in the buyback scenario at exactly the same valuation you made 180% return, but in the dividend scenario only 135% return, plus some extra taxes paid. Ofcourse the dividends were not invested, so it is slightly unfair. But if you assume the dividends were reinvested in the company at 1$ per share, that would still give you a higher return in the buyback scenario before even considering taxes.

 

And if the company would start to pay dividends after they did those buybacks, you would now get 25% more dividends, even though they return the same amount as before.

 

And this effect is even more pronounced if the company is a real bargain and buy back lot's of stock. So if you are long term oriented, and dont care about short term fluctuations, buybacks are always the better way to go.

 

If 3 investors buy stocks that are undervalued by the same amount. But one only picks companies that buy back stock, one only picks dividend stocks, and the third buys companies that leave most of the cash on the balance sheet. The investor that buys stocks that buy back their own stock is going to make by far the best return. Even though they all invest in similar stocks with similar ROE, and similar undervaluations, with similar times it take to return to fair value. Honestly, the difference between investors with a 10% return or a 30% return can be as dumb as simply picking undervalued stocks that do aggressive buy backs.

[wachtwoord]

The trick is that reinvesting dividends back into the company is cheaper than via buybacks. This is because of my small scale and because not everyone will reinvest their dividends.

[krazeenyc]

How did the conversation devolve into another thread on buybacks vs dividends?

 

The author is simply making the statement that deploying capital into buybacks is bad for GDP growth, average American worker, and the American economy as a whole.  He is not claiming that buybacks cannot generate value for shareholders.

[yadayada]

Saying companies should invest without good incentives is like saying people should buy more washing machines to stimulate the economy. Makes no sense at all. Unless you think everyone has suddenly become irrational, and there are good investment opportunnities laying out there for the taking. But even then it doesn't make sense, with the abundance of capital and all.

 

There is a reason most of that money the FED pumps into the system is not invested.

 

Also saying that buying more stock with dividends you just got is better then the company doing it instead is simply wrong . In the context of optimizing long term returns, that is not even debatable. That is like arguing gravity doesn't exist. You could literally mathematically prove it.

[ERICOPOLY]

Being in silicon valley I would prefer less investments by companies because I have seen the waste and destruction to the economy done by wasteful R&D.

 

I thought the flag in your profile meant that you are in Canada.

[petec]

 

Also saying that buying more stock with dividends you just got is better then the company doing it instead is simply wrong . In the context of optimizing long term returns, that is not even debatable. That is like arguing gravity doesn't exist. You could literally mathematically prove it.

 

Depending on the valuation!

[krazeenyc]

As value investors we care about the shareholder and shareholder value.  The author is progressive (and by the way an extremely successful entrepreneur) he is not talking about maximizing shareholder value -- he's talking about doing things to help the general U.S. economy and the average worker.

 

If you have a company that had the option to 1) buy back $2B of shares at a 50% discount to intrinsic value or 2) Invest the $2B in a new venture that say had only a 10% chance of being successful, but the possibility of creating $30B in value as well as creating short and long term employment (if successful) -- I think most value investors would choose #1. The average American worker would probably benefit more if companies chose #2.  I don't think it's crazy to think that maximizing value for shareholders is not to the benefit of the average American.

[petec]

As value investors we care about the shareholder and shareholder value.  The author is progressive (and by the way an extremely successful entrepreneur) he is not talking about maximizing shareholder value -- he's talking about doing things to help the general U.S. economy and the average worker.

 

If you have a company that had the option to 1) buy back $2B of shares at a 50% discount to intrinsic value or 2) Invest the $2B in a new venture that say had only a 10% chance of being successful, but the possibility of creating $30B in value as well as creating short and long term employment (if successful) -- I think most value investors would choose #1. The average American worker would probably benefit more if companies chose #2.  I don't think it's crazy to think that maximizing value for shareholders is not to the benefit of the average American.

 

No, they would not, because if it only had a 10% chance of being successful then 90% of such endeavours would go bust and destroy capital.  That's as bad (for the economy and shareholders) as buying back stock above IV.

 

That's why it's very important that management teams make the right capital allocation decisions, and there is an argument that cheap debt + option compensation + tax skews = a distorted incentive to buy back stock rather than invest in productive enterprise.  Stockman makes this case powerfully.

 

[APG12]

As value investors we care about the shareholder and shareholder value.  The author is progressive (and by the way an extremely successful entrepreneur) he is not talking about maximizing shareholder value -- he's talking about doing things to help the general U.S. economy and the average worker.

 

If you have a company that had the option to 1) buy back $2B of shares at a 50% discount to intrinsic value or 2) Invest the $2B in a new venture that say had only a 10% chance of being successful, but the possibility of creating $30B in value as well as creating short and long term employment (if successful) -- I think most value investors would choose #1. The average American worker would probably benefit more if companies chose #2.  I don't think it's crazy to think that maximizing value for shareholders is not to the benefit of the average American.

 

That's only half of the whole picture though. If buybacks are correctly understood as a return of capital, then you have to take into account what happens to the capital returned in option 1.

[Uccmal]

I think it is a case of this too shall pass.  At some point demand for companies will pick up enough that they will invest in projects rather than their own stock. 

 

At the moment capital is going where it is doing the most benefit to each company.  Maybe its short sighted.  If the government was concerned it could tax buybacks the same as dividends, or higher.

 

Or, like in Canada dividends could be tax advantages, somewhat. 

[yadayada]

As value investors we care about the shareholder and shareholder value.  The author is progressive (and by the way an extremely successful entrepreneur) he is not talking about maximizing shareholder value -- he's talking about doing things to help the general U.S. economy and the average worker.

 

If you have a company that had the option to 1) buy back $2B of shares at a 50% discount to intrinsic value or 2) Invest the $2B in a new venture that say had only a 10% chance of being successful, but the possibility of creating $30B in value as well as creating short and long term employment (if successful) -- I think most value investors would choose #1. The average American worker would probably benefit more if companies chose #2.  I don't think it's crazy to think that maximizing value for shareholders is not to the benefit of the average American.

Yeah but the people profiting from the buyback scenario are now richer. Index funds go up etc. That extra wealth will end up in the economy somehow. Also if those investment opportunities are decent, someone will invest. There is an enourmous amount of yield hungry capital laying around now. If nobody is touching, it probably wasn't that value accretive to begin with.

[undervalued]

Focus on the business, the numbers will follow?

 

"We don't believe in such laws as laws of large numbers," Cook said at the Goldman Sachs Technology and Internet Conference in San Francisco. "It's just sort of an old dogma, I think, that was cooked up by somebody. Steve did a lot of things for us over the years, but one of the things he ingrained in us: that putting limits on your thinking are never good. We're actually not focused on the numbers. We're focused on the things that produce the numbers." - Tim Cook

 

http://www.bloomberg.com/news/articles/2015-02-11/tim-cook-doesn-t-believe-this-made-up-math-law-will-limit-apple-s-growth?cmpid=yhoo