Buybacks get lots of bad press. Driven by low interest rates and a perceived lack of investment opportunities, American public companies spent $1.5 trillion buying back their own stock between 2013 and 2015. Critics claim that buybacks are the worst type of financial engineering, designed to prop up a company’s stock in the short term. They say the money could be better used to invest in future growth to fund research and development, capital expenditures, and marketing. Proponents claim that buybacks are efficient ways to return capital to shareholders, who can make their own capital allocation decisions, rather than allow capital to build at corporations faced with limited investment options.
A soon-to-be issued report from the Investor Responsibility Research Center Institute and Tapestry Networks takes a different approach. Rather than look at the net effect of buybacks and opine “good” or “bad,” Tapestry interviewed scores of directors to understand what was on their minds as they made the decision to institute, continue, stop, or change their companies’ buyback programs. At the time of this writing, the report has not yet been issued, but a sneak preview at July’s Stanford/International Corporate Governance Network academic day suggested some interesting findings. Directors said they supported buybacks for four overlapping reasons:
To return “excess capital” to shareholders
To invest in their own company shares
To offset executive compensation that would otherwise be dilutive
To change the capital structure of the company to better fit its business strategy
Here’s how the Tapestry research changes the conversation. Public discussion of buybacks, together with academic scholarship, tends to lump all buyback programs together and to focus on capital market impact. But boards make repurchase decisions based on circumstances specific to a corporation, and each of those reasons have different analyses that drive the decisions and different indicia of success. Let's look at each of them in turn.
The lessons for companies and boards are clear: 1. Understand why you’re undertaking a buyback program; 2. To the extent you can, eliminate unwanted consequences, such as unintended impacts on your executive compensation program; 3, Understand how you’ll define success; 4. Disclose, disclose, disclose.
To have a successful buyback program driven by a desire to return “excess capital” to shareholders, directors first have to understand the level of capital needed to execute on a company’s business plan. Directors often look at working capital needs as well as investment opportunities and dividend requirements. Success is defined as the material return of capital without affecting a company’s ability to execute on its strategic plan.
By contrast, buyback programs, which are primarily designed to invest in a company’s own shares, are driven by the gap between current market stock price and the perceived intrinsic value of the shares. Success is defined as achieving a targeted return on invested capital (the cost of the buyback). The director community is split on this rationale for buybacks. Some agree with investing guru Warren Buffet that he would not approve a buyback program absent the belief that shares are undervalued. But others note that directors and companies are notoriously poor stock pickers, and that the preponderance of evidence suggests that buyback programs do not necessarily buy back undervalued shares nor refrain from buying when shares are overvalued. Rather, buyback programs tend to occur when markets are rising.
If directors surveyed in the new research were split on buybacks based on intrinsic value, they were unified in believing that they should buy back shares to offset the dilution that would otherwise occur due to equity-linked executive compensation, and success is defined simply as offsetting dilution. Indeed, the idea that offsetting dilution is a positive was almost universally believed and almost universally unexamined. Only one director suggested that if a company was using hard dollars to buy back shares to offset executive compensation dilution, then that was also an added compensation expense. Recently, a Gretchen Morgenson column in the New York Times publicized research from Wintergreen Advisors that also made that case. The Wintergreen study suggested that the average dilution from equity compensation for the S&P 500 was 2.5 percent of outstanding shares and that the incremental cost of offsetting the dilution was another 1.6 percent. If you take that data as accurate, it adds fuel to critics’ charges that compensation cost at U.S. companies is excessive.
Finally, in rare cases, companies actually borrow to buy back shares. This is the result of a desire to redefine the balance sheet to better reflect the nature of a company’s current business opportunities. For example, if a company is transitioning from a fast-growing company with many investment opportunities to a slower-growth, mature company with more stable revenues and less need to make investments in the future, it may opt for a more leveraged balance sheet. Success is defined as achieving a new capital structure better aligned to the company’s current business.
Not surprisingly, directors interviewed by Tapestry overwhelmingly said they were actively and appropriately involved in making buyback and capital structure decisions. While a few directors suggested that the availability of buybacks and the perceived low-risk nature of them made companies irrationally risk adverse when thinking about other investments that could drive future value, most said that in the current low interest rate, low growth environment, companies could sustain both a buyback program and make all needed investments for the future.
Interestingly, the one area where directors largely agreed there was room for material improvement was in disclosure. For example, directors often said that buybacks were explicitly accounted for in making executive compensation decisions, particularly when metrics such as earnings per share (which could be affected by buybacks) were involved. But fewer than four percent of the S&P 500 disclose that fact. Perhaps that’s a contributing reason why the AFL-CIO this year introduced four shareholder resolutions asking companies to exclude the effects of buybacks on executive compensation.
More basically, few companies disclose which of the four fundamental reasons drive the decision to embark upon a buyback program in the first place. Even fewer spell out for shareholders how they test the decision against downside risks or alternative approaches to the use of capital, or how they would monitor and define success, or what steps they would take to correct course if targets were not met. Absent that disclosure, it is difficult for investors to evaluate board diligence or to judge success or failure. As one director said, “investors will stand down if they understand what you are doing; but if they don’t, they can be a little noisy."
Assuming boards are as diligent in vetting buybacks as the Tapestry research suggests, the challenge in buybacks (as in many other board decisions) boils down to making the disclosures necessary to give investors comfort that decisions are in shareholders’ best interest. This isn't just a public relations exercise. We know from social science scholarship that when bodies know they are being watched by others, they tend to do better work. The need to disclose rationales, and goals could wind up sharpening board discussions and actions.
The lessons for companies and boards are clear.
Understand why you’re undertaking a buyback program;
To the extent you can, eliminate unwanted consequences, such as unintended impacts on your executive compensation program;
Understand how you’ll define success;
Disclose, disclose, disclose.
There are also lessons for investors. As the new Commonsense Principles of Corporate Governance, drafted by JPMorgan chair/CEO Jamie Dimon and others, make clear, asset managers have an obligation to be clear about what they expect from companies in the way of disclosure. That goes as much for buybacks as for any other governance matter. Institutional investors should disclose what factors they consider in analyzing whether a buyback program is positive for a company over the long term.
If we can move toward this level of clarity by all capital market parties, it is possible to see judicious buybacks reclaiming market confidence.