The Bear’s Lair: Senator Rubio’s first good idea

Senator Marco Rubio (R.-FL.) is not a favorite of this column – he is much too fond of open-borders projects and his child tax credit was a waste of government money. But his latest idea, a tax on stock buybacks, looks well designed to remove most of this plague on U.S. corporate finance and the economy in general. If we are to avoid a very nasty recession, it should be passed as quickly as possible. Well done, Senator!

Stock buybacks have exploded in volume in the last decade, totaling over $1 trillion in 2018. The 2017 corporate tax cut, which was supposed to give U.S. companies cash flow for capital investment, has instead led to a further upsurge in stock buybacks. For many of the Fortune 500 blue-chips, the volume of stock buy-backs in recent years has far exceeded profits, let alone dividends. As set out previously in this column, this has led to a hollowing-out in the balance sheets of many large companies, with several of the Fortune 500 now operating without any equity capital at all. That has the potential to turn even a mild recession into a disastrous one, as numerous major corporations find themselves without the equity needed to raise outside money when their cash flow turns negative.

Rubio’s solution addresses the perception that stock buybacks raise the share price, by taxing the notional capital gains of both those who sell their shares into the buyback and those who don’t. Effectively, he would treat any money expended on buybacks as a dividend to shareholders, and tax it accordingly. That brings the problem that ordinary retail shareholders, who don’t normally get access to the buyback directly, would have to pay tax in cash without receiving any cash benefit.

While unfair in that respect, Rubio’s provision would have the effect of making retail shareholders a strong lobby against buybacks, a useful balance to management with share options, who benefit unfairly from buybacks compared to cash dividend payouts, which reduce the value of their options. The economic damage done by buybacks is considerable and hidden until the next recession; it will at least be useful to get an interest group fighting to diminish their volume.

It also won’t hurt that Rubio’s tax provision, unless it kills buybacks altogether, will produce a substantial amount of money for the Treasury. At the upper limit, a tax of 20%, the dividend tax rate, on $1 trillion of buybacks, would produce $200 billion per year. We won’t get as much as that, but any drop in the bucket is worth having.

That is especially true as the Trump tax legislation proved to be a lobbyist’s delight, not only cutting the corporate tax rate to 21%, further than I would have cut it (I wanted 25%) but also allowing full expensing of capital investment. When Amazon, the corporate vehicle of the world’s richest man, pays no U.S. corporate tax in 2017 and 2018, it gives credibility to the Ocasio-Cortezes of this world in their denunciations of capitalism. That policy was not only fiscally damaging, it was politically incredibly stupid – both are unsurprising, as it came from the U.S. Chamber of Commerce, famous for both qualities.

Simple folk among journalists, economists and the Trump administration celebrate stock buybacks, regarding them as equivalent to capital investment. When the tax cut passed at the end of 2017, many commentators celebrated stock buybacks as one of the uses to which companies might put their increased cash flow. After all, shareholders who benefit from selling their shares back to the company in a buyback can re-deploy their money into other shares, thus helping finance further capital investment. That analysis is false; by wrecking corporate balance sheets, buybacks suppress capital investment rather than increasing it.

Also false is the corresponding analysis among proponents of share buybacks that they must inevitably raise share prices. They do generally raise earnings per share, if money is borrowed at today’s low interest rates to finance them. If a company can borrow at 4%, and its earnings are taxed at 21%, then the after-tax cost of new debt is only 3.16%. From the pure earnings point of view, borrowing money to buy back stock is thus earnings-positive provided the stock is trading on a P/E ratio of less than 31.6 times earnings (the reciprocal of 3.16%).

However, by the stock buyback, the company has increased its leverage. Proponents of modern financial theory will tell you this does not matter; if a company can increase its earnings per share by increasing its leverage through borrowing tax-deductible debt it should do so, since it is thereby reducing its cost of capital. However, that assumes the economy trundles on along an even keel, or that the company is in an extremely non-cyclical industry. In most situations, a company can get caught out, either by being in a cyclical industry when an unexpected recession strikes, or by a sudden technological change that makes its products less attractive and new capital investment essential for survival. In either of those cases, increased leverage can be fatal.

In any case, there is another way of looking at stock buybacks, and that is by assets (yes, very old-fashioned, I know). If a company has $100 of net assets, and its stock is selling at a market capitalization of $200, being 100 shares of $2, then a $50 stock buyback reduces net assets to only $50 (possibly by taking on $50 of debt) while reducing its share count only from 100 to 75. Net assets per share have been reduced from $1.00 to $0.67. Far from selling at a higher price than $2 after the buyback, if the stock still sells at twice net asset value, it should now sell at only $1.34. Alternatively, if it continues to sell at $2, then its valuation has risen from twice net asset value to three times. The buyback is thus not a good deal for shareholders, the naïve among whom, if they did not sell into the buyback, will be expecting their stock to trade higher, not lower.

The only case in which a stock buyback would increase net assets per share would be if a company was trading in the market at below net asset value. In those cases, provided the company has adequate liquidity and is not over-leveraged, I would favor a stock buyback. The increase in the share price that it would normally produce, based on the higher post-buyback net asset value per share, would be soundly based. However, in current overvalued stock markets, those cases are very rare indeed.

The above example shows that ordinary shareholders do not benefit significantly from stock buybacks. Their earnings per share may be increased on the reduced share count, but their net asset value per share is reduced, usually more sharply than earnings per share are increased. However, top management benefits by the reduction in the share count; it can award itself stock option grants, exercise them, and allow the dilution from its issue of shares to itself to be absorbed by the reduction in share count from repurchases. For management; buybacks are a very good deal indeed; it’s just that nobody else benefits, certainly not the U.S, economy as a whole.

Apart from increasing the risk of corporate bankruptcy, buybacks have an additional, killer defect in forcing shareholders over a business cycle to suffer from the ineptitude of management’s stock market forecasting. When business is good and stock prices are high, management sees the possibility of “returning cash to shareholders” by means of larger buybacks. Then when recession hits, companies may be forced to do emergency share issues at low prices, even if they do not go bankrupt. Selling something for $4 and buying it back for $1 is a huge waste of the shareholders’ money – but management gets to cash out its options at the top and award itself new lower-strike-price options at the bottom. Needless to say, given its own “skin in the game,” management is less than averagely competent at forecasting the best times to do share buybacks.

The fad for stock buybacks is yet another ill-effect of the period of ultra-low interest rates through which the U.S. economy has suffered for the last decade. Money has been readily available and cheap for large corporations, so has gone into this as into other forms of unproductive investment. Now Senator Rubio wants to tax these activities. As we said above, we do not often agree with Rubio, but even a blind pig will find a truffle occasionally. This is one of those occasions; his initiative should be supported.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)