Swedroe: Don’t Demonize Buybacks

A common critique of stock repurchases is that each dollar used to buy back company shares is a dollar not spent on business activities that would stimulate economic growth. Another critique is that, instead of buying back shares, the company could use those same dollars to return capital to shareholders in the form of dividends. Both of these critiques, which tend to figure prominently in the media, are misplaced. Let’s see why this is the case.

Franco Modigliani and Merton Miller, both Nobel Prize-winning economists, are perhaps most famous for their proposition that, in the absence of taxes (and a few other assumptions, such as efficient markets), it does not matter what capital structure a company employs to finance its operations.

They theorized the market value of a firm is determined by its earning power and the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends. Of course, in the real world, companies and investors face taxes, which gives corporations an incentive to use leverage (due to tax deductibility of interest), at least to an optimal level.

The Modigliani/Miller theorem is often called the capital structure irrelevance principle. In other words, without considering taxes, whether a company uses cash to pay a dividend, repurchase shares or make an investment, its cost of capital (and thus the return to shareholders, the flip side of the cost of capital) is unchanged. This has been the operating model in finance for more than 50 years.

Share Repurchase Myths

In a December 2017 paper, “The Premature Demonization of Stock Repurchases,” AQR Capital Management’s Clifford Asness, Todd Hazelkorn and Scott Richardson address four myths related to aggregate share repurchase activity. They show:

• While total dollars now spent to repurchase shares is high relative to history, companies are not “self-liquidating,” as some claim. Instead, repurchases have been largely financed by debt issuance. In fact, when scaled by market capitalization, the upward trend in share repurchases over the last five years disappears.
• There is no obvious link between aggregate share repurchase activity and a decline in aggregate investment activity. First, net equity issuance over the last five years has been positive. Second, share buybacks have been funded by an increase in historically cheap (and tax-subsidized) debt, not a decrease in investment. In other words, share buybacks have been a form of recapitalization, and a shift from equity to debt financing (which is logical in light of today’s historically low real interest rates). Third, there’s no apparent negative relationship between normalized investment and share repurchase activity. In fact, the two variables have been positively correlated of late, as both investment and share repurchases have increased since the end of the global financial crisis.
• Aggregate repurchase activity is not, and cannot be, responsible for strong equity market returns over the last eight years—share repurchases are not “propping up the market.”
• Aggregate repurchase activity is not associated with mechanical or automatic earnings-per-share (EPS) growth, as is often claimed. Specifically, the claim is that, by repurchasing shares, a company decreases its share count, and so mechanically increases its EPS. But this ignores the fact that decreased cash can mean lower earnings, either due to less interest earned on that cash (or greater interest expense if debt is used to finance repurchases) or the loss of returns from other uses for it. In addition, the assertion that any increase in EPS leads to a commensurate increase in share price reflects a naive understanding of basic corporate finance (e.g., Modigliani/Miller). Any increase in leverage that increases EPS increases risk at the same time, with the net effect being a wash on firm equity value. Empirically, no clear link exists between share repurchases and EPS growth. EPS growth rates for firms that do not repurchase shares are approximately 1% higher than EPS growth rates for firms that do repurchases shares.

Benefits Of Buybacks

It’s also important to remember that, as Asness, Hazelkorn and Richardson note, “investors’ proceeds from share repurchases do not simply disappear. Rather, these funds are received by equity investors, who can (and do) allocate the proceeds elsewhere, thereby funding other investments. In fact, the redirection of available capital to the best available investment opportunities is the very purpose of a well-functioning capital market.”

Furthermore, there are logical reasons for investors to have a favorable view of share buyback programs. For example, repurchases might signal that management believes shares are undervalued. (If management believed they were overvalued, it would instead choose to pay a dividend, or it could choose to issue more shares.)

In addition, buying back shares is inconsistent with the idea management is forgoing attractive investment opportunities. What’s more, because interest payments are tax deductible, debt-financed repurchases can be viewed as good news due to the resulting lower tax burden. Another benefit is that share buybacks reduce agency risk; that is, management engaging in “empire-building” acquisitions (the same argument those that have a preference for dividends make).

Asness, Hazelkorn and Richardson note these factors help explain findings in academic research that “the announcement impact on returns of share repurchases is between 1% and 2% on average repurchases”—a small, but positive, affect.

Another important point is that taxable investors should have a preference for buybacks over dividends—a point that investors with a preference for dividends often ignore. The reason is that, unlike with dividends where taxes are paid on the full distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And if the investor does not need the cash flow, the buyback avoids paying any tax (at least until the shares are sold).

Summary

Asness, Hazelkorn and Richardson concluded: “Aggregate share repurchase activity has not been at historical highs when measured properly, and when netted against debt issuance is almost a non-event, does not mechanically create earnings (EPS) growth, does not stifle aggregate investment activity, and has not been the primary cause for recent stock market strength. These myths should be discarded.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.