The Bear’s Lair: Time to ban stock repurchases

Boeing (NYSE:BA) and the airlines are currently in negotiations with the Trump administration for a bailout, with taxpayers expected to replace capital that those companies had previously eliminated through stock buybacks. If they get money without being forced through bankruptcy, this will become a pattern in each business cycle because it is so beneficial to incumbent management with stock options. It is now clear that stock buybacks are a rip-off of taxpayers; we already knew they were a rip-off of ordinary non-management shareholders. They must be outlawed, as they were before 1982.

Before 1982, stock buybacks were prohibited by the SEC, as they were thought to be a manipulation of the trading market in the stock, giving advantage to well-connected and insider investors over others. The only way a company could buy back its stock was through a public tender offer to all shareholders, advertised in the press and with offer documents mailed to every shareholder. Since that process was expensive and ran the risk of difficult questions being asked at a shareholders’ meeting, it was undertaken very rarely.

The SEC’s pre-1982 view of stock buybacks was correct. If the buyback offer is not extended to all shareholders, it inevitably provides an advantage to insiders and those with connections in the company. Following the scandals of the late 1920s, this was regarded as unacceptable; while the ability to trace “insider trading” is much greater today than it was in 1982, let alone 1929, the potential for abuse still exists. Subsequent experience has shown however that this is by no means the only problem with buybacks.

In 1982 the SEC issued Rule 10b-18, permitting companies to buy back their stock without making a full public offer. This rule was the result of intensive lobbying by CEOs and a general spirit of de-regulation among the SEC Commissioners appointed by the new Reagan administration. It also had a certain economic logic; stock prices had declined by 75% in real terms since 1966 and were in 1982 at real-terms levels not seen since the 1930s.

Hence stock buybacks in the early 1980s often represented good economic value for shareholders – it could be argued that shareholders as a whole would benefit from stock buybacks at such low prices. If a company’s shares were trading at 50% of net asset value, a stock buyback would increase the net assets per share available to other shareholders, and probably their earnings per share also. Needless to say, such favorable economics have now not been available for many years, even at the bottom of the 2007-09 bear market.

During the 1980s, buybacks remained relatively scarce, for one reason – relatively few CEOs were at that stage remunerated by more than modest grants of stock options, and hence there was no especial benefit to management from an aggressive program of stock buybacks. This changed with one of Congress’s more foolish tax changes in 1993, by which CEO pay above $1 million ceased to be tax deductible at the corporate level, but “incentive” pay including stock options and performance-related bonuses was excluded from this deductibility cap.

The result was a massive ramping up of CEO “incentive pay” and especially CEO incentive stock options. This coincided with the massive run-up in stock prices in the late 1990s (goosed by the looser Fed monetary policies after 1995). With CEOs being paid increasingly in stock options, they quickly came to notice that stock buybacks increased the value of their stock options, whereas cash dividends didn’t; they merely gave money away to the little people who owned shares. So was born the massive conflict of interest between top management and ordinary shareholders, which has continued to this day. Top management love stock buybacks, whereas they begrudge dividends. In the cheap-money era since 2010, the volume of stock buybacks has exploded; stock buybacks by the S&P 500 totaled $806 billion in 2018, a further $710 billion in 2019.

Stock buybacks appear to have worsened a long-term trend, whereby companies do not invest sufficiently in their own business. This trend dates back many years, to the adoption of discounted cash flow, with a “hurdle rate” of the company’s cost of capital, which took place mostly in the 1960s. While theoretically elegant, the DCF methodology required a company to estimate sales, costs and profits relating to a new project a decade into the future, generally impossible to do with any pretense of accuracy.

Even conceptually, this had adverse effects on U.S. business. For one thing, have you noticed that there are now no long-term research and development operations like Bell Laboratories and the Xerox Palo Alto Research center? (Alphabet (Nasdaq:GOOG) and Facebook (Nasdaq:FB) have set up limited versions of those operations, to be fair.) Discounted Cash Flow had much to do with this: it was impossible to determine the long-term profit from inventing the transistor or the mouse before you had invented it. Hence Bell Labs came to appear a pure cost center and disappeared after AT&T was broken up in 1982. In general, DCF requires you to have a clear idea of what you are trying to build and the potential market for it; it therefore fails badly on the longest-term projects where those factors cannot be known.

Relying on venture-capital-funded small business to perform the fundamental innovation function does not work; the venture capitalists will take a chance, but they want rapid returns and hence tend to fund only limited technological advances with a lot of marketing hype behind them. William Shockley, the inventor of the transistor, failed in independent business and never became a billionaire, yet his invention has had more value than Google and Facebook together, both of which would have been impossible without him.

Stock repurchases have a killing effect on capital investment in a DCF world. They are treated as having the same return as the company’s return on equity, so look attractive compared with many new projects, which may carry a lower-than-average return. There are two flaws in this calculation, however. First, if a stock has a return of 12% on book equity, and is trading at three times net asset value, then the true return of a stock repurchase is not 12% per annum but 4% per annum, because the repurchase only eliminates one third of the shares it would eliminate if the repurchase were carried out at book value.

A second problem with the DCF/hurdle rate approach is that interest rates have declined so far and P/E ratios increased so much that the historic hurdle rate is generally set far too high, eliminating projects that would increase shareholder wealth if carried out. If a company is capitalized 50:50 between debt and equity, its debt costs 3% (so 2.37% after corporate tax) and its shares are trading at 20 times earnings, then its cost of capital is not 10% but 3.69%. Add a margin for safety, and such a company should be using a 5% hurdle rate, bringing a whole new range of projects into feasibility, especially those with a long payoff period (whose returns will be discounted much less than with a 10% hurdle rate.)

As price-earnings ratios and price to book value ratios have increased, the effect of stock buybacks on capital investment have become more severe. In 2018-19, it is lucky that any capital investments got started at all, except for the simplest, most short-term projects.

The current downturn has brought into focus a further problem with stock buybacks, which I have discussed before: they de-capitalize companies in bull markets, then require either shareholders or taxpayers to re-capitalize them in the downturn. From top management’s point of view, this is fine – they make huge amounts of money on their stock options as stock prices soar, then maybe miss out for a year but get to re-set the exercise price on their options at the bottom of the market. For ordinary shareholders, stock buybacks in a cyclical economy are a nightmare. Boeing shareholders, for example, were buying back shares at $400 per share in early 2019; it is likely that they will now have to recapitalize the company at the bottom, probably at around $100 per share. Management has got rich, but shareholders will not — buying for $400 an item you later re-sell for $100 has never been a profitable business.

Banning stock buybacks will eliminate the over-leverage of major U.S. corporations, reduce the remuneration of their top managers to more mortal levels, and increase the willingness of U.S. companies to invest in the future. The only losers from this regulatory fix will be the lobbyists.

(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.)