Buybacks by quarter, courtesy of S&P by way of Yardeni Research.
One of the classic tropes of lazy financial journalists goes like this: XYZ Co spent half of their free cash flow on buybacks this year, but the stock dropped! They lost their shareholders billions of dollars! What morons.
It’s always strange how the best stock pickers are people working as journalists, and they only publish their ideas after the fact. The Hindsight Portfolio has an absolutely outstanding Sortino ratio; they should start a fund.
For those of us who are stuck doing things the old-fashioned way, making decisions in the present based on the data we have now rather than what we’ll know in twelve months, buybacks present a fun theoretical puzzle: is their purpose to generate excess return, or is it something more prosaic?
I’d divide the conventional wisdom into two camps:
- Alpha Buybacks: the theory here is that the point of a buyback is to buy low and sell high; companies should buy back their stock when it’s materially underpriced, and issue stock when it’s not.
- Beta Buybacks: this theory holds that buybacks should be fairly indifferent to valuation; companies can use them as an efficient way to return capital to shareholders, with some side benefits, even if they do buy high and sell low from time to time.
The Theory of Alpha Buybacks: A Loyalty Test
In a benign sense, this theory is fine. It takes two sides to make a market, and sometimes the cost of capital gets out of whack with a company’s available opportunities. In the extremely benign sense, one could describe the alpha buyback approach by using T. Boone Pickens’ 80s analogy: sometimes the cheapest place to drill for oil is the floor of the New York Stock Exchange.
What it sets up is an adversarial relationship between a company and its shareholders, with full disclosure as the victim. A company can generate faster per-share earnings growth if it buys its stock cheaply and sells it dearly, arbitraging the difference between real and perceived future returns in its business. And the company has a way to do that: it can mislead investors. You’d expect a company using the alpha-buybacks model to constantly whipsaw its shareholders: talk up how great their business model is and how fast the market is growing, then issue a bunch of stock; complain about competition, make some painful investments that compress margins in the short term, write down some assets, then buy stock back at a discount.
Of course, the investing public learns which managers to trust. “Promotional,” for example, is the term for managers whose optimism is within the range of pathological but isn’t actively fraudulent.
But even this sets up a harmful dynamic: it means the company is constantly subjecting shareholders to an implicit loyalty test: when management says there are challenges, you get paid if you believe they’ll survive. (It’s a loyalty test in the other direction, since selling when prices are high and times are good means putting your stock in the hands of the company’s fair-weather friends.)
Management and shareholders don’t ever have perfectly aligned incentives (does the company car really add that much shareholder value?) but there’s no reason to set them in opposition. That’s what the Alpha Buybacks Theory does.
It’s worth asking: why do companies think they’d be better at timing the market in their own stock than the average investor? I blame ingrained corporate optimism.
Companies’ executives are naturally optimistic about their own prospects. There are two good anthropological explanations for this:
- The management-selection effect: Consider two people who are rising in the ranks at a given company. Alice and Bob are both smart, hard-working, and charismatic. They’re both seen as CEO material. Alice is a careful thinker who maps out risks and considers the downside; Bob is an incurable Pangloss who only cares about upside. Who will end up running things? It’s a trick question, because it depends on how the company performs: if times are bad, Alice will do better than Bob, but she’ll have a bad name on her resume (if the company underperforms for company-specific reasons) or be stuck in a bad industry (if the problems are more systemic). When things go well, though, the risk-takers win the most. So merely by virtue of his inability to see downsides, Bob gets the promotion. Selection against optimism takes place on a more macro timescale, and selection for optimism correlates with opportunities for promotion. Sorry, Alice.
- The thesis-selection effect: Suppose a company has launched a bold new strategic plan. There’s a lot of debate among investors as to whether or not it will work. Let’s say the stock is at $50, and if the plan works well, people agree that the stock would go for $60. If the plan goes poorly, it’ll trade closer to $40. Clearly, management will tend to think the plan will succeed, i.e. they think $60 is a fair value — if they didn’t, they would have chosen a different plan. So every management team everywhere tends ot think the street underestimates their strategic sagacity. Probably a healthy bias to have, at least in moderation.
Over time, selection for optimism means selection for executives who execute what looks to them like an Alpha Buyback (buy low, sell high), but which in fact turns out to be a Beta Buyback (buy whenever you have money).
The Theory of Beta Buybacks: Simplicity, Liquidity, and Low Taxes
The beta buybacks theory starts with the idea that a company that generates cash can either retain it or distribute it. Since the company’s value is theoretically the sum of all the cash flow it distributes to shareholders over its existence, optimal distribution is important. For US taxpayers, earning a dividend is less tax-efficient that owning an asset that appreciates, because the capital gains tax is paid only at the end of the holding period, while dividend taxes are paid on every check. This is a small difference in the short term, but compounding is magical: a 7% annual return taxed each year at 20% is 5.6% compounded. 7% over twenty years, taxed at 20% at the end, is 6.1%. Or in total gain terms, you’re looking at a 229% gain under the buyback model versus a 197% gain with dividends (making the unrealistic assumption of a 100% payout rate and continuous reinvestment at the same price).
Continuous buybacks serve another purpose: they provide a consistent source of liquidity to shareholders. There’s a longstanding debate between traditional value investors and financial theorists over whether or not liquidity is a good thing: the traditional investors note that the point of investing is to own a stake in a business, and that if you invested in a friend’s new startup because your friend made it clear you’d be able to yank your money easily, this would indicate a lack of confidence on your part, and maybe some unseemliness. Financial theory tells us that a more liquid asset is more valuable since someone who does change their mind doesn’t have to wait around to get out.
Fortunately, rather than resolve this interminable debate between people quoting formulas and people quoting Warren Buffett, we can just note that each side is the other side’s Dumb Money:
- More liquidity from a company consistently buying back stock lowers the risk to high-frequency traders and other market-makers.
- This liquidity encourages fast-money traders, who take positions with plans to exit in a timeframe of days to weeks.
- These traders offer still more liquidity to long-term investors, who can carefully analyze the company and make a long-term bet. Crucially, more liquidity lowers the company size threshold for a given long-term investor, meaning that smaller companies get attention from smarter people.
Since “liquidity” means somebody to trade against, this is karma on both sides: to the financial theorist, overconfident and under-diversified investors overpay for liquidity; for Buffett fans, those same liquidity providers are on the wrong side of a good trade.
The final concern a company has when it decides between buybacks and dividends is signalling. Nobody likes to cut a dividend, so historically companies set their dividend at the amount they’d expect to be able to pay during bad times. So setting a dividend is an implicit statement about the durability of a company’s business. Dividends are also a little more prestigious than buybacks; for some reason, the media don’t complain so much if a company pays a big dividend when markets are high and then cuts it when they’re low, even though the dividend buys a lot more stuff in a bear market.
Signaling risk introduces a paradox that muddies the waters on buybacks. One reason cynics allege that companies buy back stock is to artificially inflate their share price: simple supply and demand. But dividends also inflate share prices (or, at least, dividend cuts decrease share prices; since dividend cuts are bigger than dividend increases, it’s likely that the “dividend premium” is too small to measure, but not that it doesn’t exist).
For shareholders, and for society as a whole, the alpha buyback model is undesirable. It encourages companies to offer less information, or even misleading information. If you’re a shareholder, you want to be on the same side as management, and you want them to have an incentive to communicate fairly with you, not to jiggle the stock price around for their benefit. There’s a reason stock exchanges regulated insider manipulations even before the SEC existed.
Alpha buybacks also encourages good market timers to work as CFOs rather than as investors, which reduces the number of beneficiaries of their timing. This is not ideal: if someone has a talent for making investments, the ideal is for them to exercise that talent over many companies: the whole point, from society’s perspective, is to move capital from poor prospects to good ones. If you’re only able to move capital from one prospect to the general market, you’re straitjacketed: you’ve taken a thousand-answer multiple-choice question and boiled it down to true/false.
If anything, we should applaud it when companies buy back a bunch of stock and the stock subsequently goes down. While that’s not desirable for their shareholders, it’s great for everybody else.