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Economics & Finance

Share Buybacks Are Corporate Suicide

Robert Ayres, INSEAD Emeritus Professor of Economics and Political Science and Technology Management, and Michael Olenick, Institute Executive Fellow at INSEAD |

When firms invest too heavily in buying back shares, there is likely to be trouble ahead.

The revival of supply-side economics, exacerbated by the election of U.S. President Donald Trump and his promises of pro-business reforms, is doing little to increase the rate of economic growth and improve returns for long-term investors, such as pension funds. In fact, the current management love affair with share buybacks is having quite the opposite effect.

At first glance, stock buybacks may seem a good way to enhance value for the shareholders. By reducing the number of shares outstanding, firms can hike up their earnings per share and inflate share price, to the benefit of hedge funds and other short-term investors. Other winners are top corporate managers who are allocated a large proportion of their pay through stock-based instruments and receive bonuses triggered by a rise in the share price. If things look solid, long-term investors may have no problem with this, but what if the money spent on buybacks is money that would otherwise be spent on new product development and innovation? Worse, what if that money is borrowed?

Buybacks affect a firm’s ability to survive and grow

When share repurchases increase debt and reduce spending on innovation and R&D it directly affects a firm’s long-term ability to survive and grow in a disruptive and uncertain business environment. Meanwhile, the question arises: What happens to the money that is "returned" to shareholders by share buybacks? Economic theorists suppose that this money will be re-invested in more promising opportunities. What seems certain is that much of the money will be ploughed into ever-riskier investments in the search for even higher returns.  We suspect that much of the money spent on buybacks by established "mature" companies has created a stock market bubble in FAANG stocks (and others) where conventional PE ratios no longer restrain investors in search of growth.

Buybacks and a decline in market value

To get a better understanding of the impact of buybacks, we set out to compare the performance of companies that rely heavily on repurchasing shares with those that do not. Our study, "Secular Stagnation", examined 1,839 public companies in the United States over a five-year time‐scale. We found that the more money a firm spends on buybacks, the less likely it is to grow over the long-term. In fact, as the chart below makes clear, we discovered that not only do buybacks not lead to growth in a company’s market value, they are strongly correlated to a declining market value.

There are many high profile examples of the impact of excessive buybacks at the expense of healthier re-investment. Take IBM Corp, which has spent US$125 billion on buybacks since 2005, and $32 billion on dividends, while laying off large numbers of employees and investing only $69.9 billion in R&D. We wonder: What If the 20th century computer giant had spent a lot less money on share buybacks and more on pre-empting the innovations stemming from its nimbler competitors in Silicon Valley?

General Electric is another case in point. The world is electrifying, but without GE. It repurchased US$114.6 billion of its own stock and by the end of the first quarter of 2016 had a market capitalisation of $253.25 billion, a ratio of 45 percent. Its stock underperformed both on the S&P 500 and in comparison to competitors such as United Technologies (40 percent), Honeywell (22 percent), and Danaher (2 percent), all of which grew their market value faster than GE while spending less on buybacks.

And there’s more. Sears spent US$6.92 billion buying back its own stock. The company is now only worth $729 million. Over the past five years Sears has seen its market value contract by 87 percent. Consider HP, the grandfather of Silicon Valley, which spent US$81.56 billion on buybacks but contracted 25 percent in market value over the five-year period. Or Xerox, which spent US$8.6 billion on buybacks and is now worth only $7.2 billion, having contracted by 30 percent.

In fact, 64 companies in our review, including retailers The Gap, JCPenney and Macy’s, spent more buying back their own stock than their businesses are currently worth in market value. The management at Target spent 95 percent of its current market value buying its own stock.

On the flip side, we identified 269 companies that repurchased stock valued at 2 percent or less of their current market values, (including Facebook, Xcel Energy, Berkshire Hathaway and Amazon). All are strong market performers.  To say the least, the evidence does not suggest that buybacks are good for long-term growth. In fact, far from suggesting that buybacks are a sign of confidence in the future by top executives, the evidence suggests the opposite:  Buybacks are a way of disinvesting – we call it "committing corporate suicide" – in a way that rewards the "activists" and executives but hurts employees and pensioners.

A growing phenomenon

Stock buybacks are a relatively new phenomenon in the U.S. They were only legalised in 1982, when President Ronald Reagan’s newly appointed Chairman of the Securities and Exchange Commission (SEC), John S.R. Shad "re‐interpreted" banking legislation from 1933 that prohibited firms from purchasing their own shares in the stock market.  At first, the money spent buying back shares was negligible, but by 2000, 38 percent of the earnings of large U.S. companies was spent on buybacks and dividends. This steadily increased to 79 percent in 2011, before soaring to 110 percent in 2015; fuelled by demand for ever higher quarterly earnings per share and so‐called “activist” investors.

For reasons deserving another article, the shareholder value‐maximisation (SVM) ideology has been accepted in most corporate board rooms and promoted as a legal obligation on the part of executives ("agents") to the shareholders ("owners"). As William Lazonick has also pointed out, this logic is false. In law, companies own themselves and executives are supposed to do what is best for the company, using business judgment. We doubt that corporate suicide is the right policy for most companies, even those facing great disruptions.

Robert (Bob) Ayres is an Emeritus Professor of Economics and Political Science and Technology Management at INSEAD and the Novartis Chair in Management and the Environment, Emeritus. He is the author or co-author of 23 books and many journal articles.His latest is Energy, Complexity and Wealth Maximization.

Michael Olenick is a research fellow at INSEAD.

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Comments
AJ,

As with most things, it depends on the circumstances - to say 'share buybacks are corporate suicide' isn't a sensible conclusion. For a clear, balanced view i'd encourage people to read Buffet's 2016 letter - skip to pg 7 - http://www.berkshirehathaway.com/letters/2016ltr.pdf

David Abashidze,

Very misleading and incorrect article:
1) Share price is boosted after buybacks because buybacks are sometimes perceived as signal of stock’s undervaluation – “if most knowledgeable people about the company, the management, are buying it then we should buy it too” logic. In cases when buyback are simply used as alternative to dividends for investors then share price usually remains about the same and as EPS is increased P/E adjusts downward – this is elementary corporate finance math. Share price is NOT BOOSTED due to increase in EPS, as P/E does not stay the same after buybacks. efficient markets never increase value due to EPS gaming and accretion/dilution, this has been demonstrated by many researches.
2) Share buybacks are flexible alternative of dividends. The companies are created to make money for investors and eventually to return money to investors, so that investors buy things they want. If investors don’t receive their money back no one will invest eventually and the whole system will collapse. If company is buying back share it is effectively making special dividend and it means that company does not have better alternative to invest this money in value creative projects. So money is better to be with investors who can invest it in alternative companies and make consumer spending.
It is disappointing that I have to write about such elementary principles of capitalism and corporate finance here

JJ,

I am inclined to a similar skepticism about share buybacks’ value to our economy; however, this analysis has me a skeptic of the skeptics. Examples of heavy users of buybacks are 1) IBM, Xerox and HP. Management of these firms got out of the innovation game going back decades, well before they began buying back shares. IBM and Xerox have been the topic of “what went wrong” retrospective books and investor discussions for ages, 2) Gap, JC Penny, Macy’s and Target are all in conventional brick and mortar retail and that entire sector is taking a massive hit due to online buying, 3) Sears has been in trouble for a very long time, again decades.

In these cases it raises the question whether, to a shareholder with investments stranded there, buybacks would be all about returning what remains of their accumulated wealth *now* since the writing is on the wall. Makes great sense actually. Meanwhile, the FAANG stocks still expand, still buy up other firms in new markets, still have immense commercial
engagement and energy in the marketplace. If anything, spare money from investors seeks from them more optimistically than they might be able
to deliver.

In the end, this study really reads like a selection bias. The dynamic earners don’t do it, the non-dynamic players do, AND correlation still does not equal causation. All we confirm is that maybe shareholders deploy different particular strategies in different particular circumstances. Thank you Captain Obvious. Perhaps it indicates a worrisome generalized shortage of dynamism and hope of profit potential across our entire constellation of public companies.

I would suggest a root cause that leads to non-dynamism in companies is the larger public company culture that insists on executive talent that’s hyper-specialized on balancing books and managing people as general business management skills rather any knowledge or passion about the specific business in which management is engaged in managing. The least dynamic companies are always faceless vague brands managed by folks who wear a suit well but have neither clue nor attachment to their specific industry, little idea where it’s headed and no eagerness to gamble (perhaps shareholders even punish any signs of willingness to gamble). That gambling instinct is key to capitalism, that can take a firm in a direction of far vaster returns than mere bean counting and reduction of product and labor costs can ever do. I see no signs that this culture will change any time soon, hence we have seen the rise of disruptive startups, unburdened by any of that legacy, some of which are now called FAANG’s.

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