Rolling the dice on stock buybacks

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A recent opinion piece in the New York Times suggested that we need restrict stock buybacks in order to “save the economy.” [1] While the authors make some good points about long-term effects, I want to lay out a more basic position here. The fundamental problem with stock buybacks is that they are wise financial moves at most 50% of the time, and dumb the other 50% of the time. Complicating that probability, corporate boards and executives are often the last people to know which 50% group they are in. In short, it is a flip of the coin, or in the spirit of this blog, a roll of the dice.

I noted in a post back in January that a primary result of the late-2017 corporate tax cuts would be to increase stock buybacks, causing feeble reinvestment of tax savings. In May of this year, Goldman Sachs was reporting a 48% rise in stock buybacks over the preceding year. [2] I’ll present my analysis of this trend in several steps beginning with one key and debatable assumption:

The “strong enough” form of market efficiency assumption

Whether the public market for stock measures the price of shares “efficiently,” that is, fairly valuing all available information about a company’s future earnings, has been a longstanding debate. [3] There are “weak forms” and “strong forms” of market efficiency, but I suggest that the appropriate model here for corporate managers and directors is that the market is “efficient enough for the crowd you hang out with.”

In other words, corporate executives and directors have never been shown to be particularly savvy about the market value of their own stock, apart from insider information, and often even that does not help. Since companies embarking on a major stock buyback are making a “big bet” on the market price of their own stock, the assumption of where they fit in the population of stock price analysts is critical. For my analysis to work, it only requires that most of these decision-makers are somewhere in the middle of the pack, but at the same time most would never admit that. [4]

What is the buyback transaction, really?

A stock buyback is two things. First, it is an outflow of excess cash to a set of investors (and so in that way like a dividend) and second, it is the purchase of a substantial block of stock at the market price, or even a premium above the market price (which is not like a dividend and there’s the rub). Overall relative ownership by remaining stockholders theoretically goes up per share by the pro rata amount of the buyback, so this is kind of a dividend, but intended to be in the form of an unrealized capital gain for the stockholders who stick around.

What was that market price again?

Our “strong enough” model of market efficiency says that the share price before buyback is most likely “fairly priced” for the marginal shareholders, who are those people right on the bubble between buying and selling. In other words, the odds of the stock price going up or down in the near term are quite close to 50-50, adjusted for the overall bear or bull market trend. All stocks on average, or in your sector, may be falling or rising and you are likely in that tide.

That general tide up or down is a major factor in what makes evaluating market efficiency so hard. If the price of the stock goes up more than the pro rata buyback cash spent, was that because the market favored our buyback, or because the industry/market trend was going up anyway? Generally, managers will say “We did this” if the price goes up, but that may not be the case.

Because of the “adjusted” 50-50 odds, the re-purchase of your own stock is likely to be “smart” only half of the time and “unwise” the other half of the time. If managers and directors really thought the price was going up soon, they should all be buying privately in the market (in legal ways). But they often are not buying privately, lurking at best among those “marginal shareholders.” In short, their confidence in the value of their own stock has its natural limits.

The accounting façade

One cynical reason to do stock buybacks is that the stock price typically goes up without any change to what the company is actually doing. If executive bonuses are based on stock price and not adjusted for the “accounting trick” of a stock buyback, then the executives are just “gaming” their bonus, which I would suggest is a “bad thing” if you are an outside stockholder.

The cash side of this accounting for a stock dividend raises a critical question. In effect, the company is saying, “We don’t have anything better to do with this cash. We have no good investment opportunities for future growth, and we do not want to pay this cash to employees or improve their work environment.” This seems to me this also is a “bad thing” from a market perspective. Which way will the market for your stock take it?

The second accounting trick here is that treasury stock, which is what these re-acquired shares are called “on the books,” is not held as an asset, as stock purchases in other companies would be. Rather, this stock is shown as a “contra-equity” in the stockholders’ equity section of the balance sheet. Importantly, this reduction of equity is valued at the actual cost (that market price or price-plus-premium) of the repurchased shares, and it is never subsequently adjusted up or down depending on whether the market price for your stock goes up or down in the future. And thus, there is no accounted-for gain or loss to later audit the wisdom of this decision as there would be with other stock purchases. And so, the “downstream” impact of this corporate decision will be quite hidden from future analysts and outside shareholders.

The above-referenced New York Times article discusses some other negative “downstream” effects of stock buybacks, particularly in their impact on rising income inequality. These are good fodder for a later post that is in the queue. My assertion here is that managers and directors are working against a strong headwind of “market efficiency” when they enter the public market for their own stock. Even if you think you personally can beat the market, you are facing a lot of data that says otherwise. But then, much of the gaming industry depends on people believing that they can “beat the house” when playing craps. [5]

A follow-up to this post, looking at the impact of stock buybacks on income inequality, has now been posted.


Notes:

  1. Lazonick, William, and Ken Jacobson. “End Stock Buybacks, Save the Economy.” The New York Times, 23 Aug. 2018.
  2. Vlastelica, Ryan. “Here’s What Tax Reform, so Far, Has Meant for the Stock Market and the Economy.” MarketWatch, 24 May 2018.
  3. Burton Malkiel’s classic text on the subject, through its many editions, remains the most accessible discussion of this concept. Malkiel, Burton G. A Random Walk down Wall Street: the Time-Tested Strategy for Successful Investing. W.W. Norton & Company, 2016.
  4. I am ignoring here the “known inefficiencies” such as the arbitrage practiced by high-speed traders like Tradebot Systems. I call this approach “penny sucking,” where the complications of trading technology and time delays leave tiny amounts “on the ground” available to sophisticated computer algorithms, multiplied by millions of trades. Most corporate board members don’t have access to “penny sucking” opportunities, and so they are more likely to be buying and selling in an “efficient enough” space.
  5. I wrote about my favorite graph demonstrating market efficiency in an earlier post entitled “Visualizing 7% investment risk.”

 

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