In this opinion piece, Wharton finance professor Michael R. Roberts examines some of the arguments against stock buybacks and explains why buybacks are an important mechanism for returning money to investors and avoiding unprofitable investments.
Stock buybacks, or share repurchases, have been the focus of some vitriol as of late. President Biden castigated companies for repurchasing shares in his State of the Union address. In contrast, Warren Buffett referred to detractors of share buybacks as “economic illiterates or silver-tongued demagogues” in his annual letter to Berkshire Hathaway shareholders. Both sides have vested interests. Which is right?
Why Do Firms Repurchase Their Shares?
The primary rationale for stock buybacks — and dividends — is as a means for returning money to investors. Shareholders give money to companies because they expect more money in return. Selling shares back to the firm is one way investors get that money.
There are several other reasons firms repurchase their shares. Firms may believe their shares are undervalued by the market. Purchasing shares on the cheap creates value for long-term shareholders much like a profitable investment. Alternatively, firms may use repurchases as a signal to the market that they are well-disciplined, returning excess cash to investors instead of investing it on wasteful projects or letting it sit idle in low-yield cash accounts. Finally, repurchases help support stock-based compensation plans while mitigating any dilutive effects of stock issuances.
Fundamentally, stock buybacks are aimed squarely at returning money to the investors taking the risk of providing capital to firms.
Repurchasing shares has a negligible effect on share prices in the short run according to empirical research, and does little to increase future cash flow.
Stock Buybacks: The Arguments vs. The Facts
Argument #1: Firms should invest instead.
The Facts: Biden’s attack on buybacks centered on an alternative use for firms’ cash — investment. But if firms have profitable investment opportunities, they will prefer to invest the cash rather than repurchase shares. Investing in profitable projects has a large and (near) immediate impact on share prices. It also generates future positive cash flow. Repurchasing shares has a negligible effect on share prices in the short run according to empirical research, and does little to increase future cash flow.
Argument #2: Buybacks are basically “paper manipulation.”
The Facts: Another argument against buybacks put forth by Senator Elizabeth Warren is that they are tantamount to “paper manipulation.” She noted:
They got a little fluff-and-buff in their stock. And how did they do that? By taking their excess cash and saying, ‘Geez, we can’t figure out anything to do with this cash. We’re not going to give it back to our investors. We’re going to make the investment decision that the only investment in America that makes any sense is to buy back our own stock.’
First, the very nature of a share buyback is to give money back to shareholders, i.e., investors. So, the argument that the firm is not giving cash back to investors is nonsensical.
Second, often for many firms, the only good investment is to return money to their investors. Recessions, industry downturns, reductions in demand, etc., all lead firms to slow their investment, and rightly so. Investors don’t want firms wasting their money on unprofitable investments. Additionally, some firms accumulate so much wealth that there just aren’t enough profitable investments. Apple’s $285 billion cash pile in 2017 is a good example. Ultimately, if managers were repurchasing shares at the expense of profitable investment opportunities, it’s not clear why the market would consistently reward them, as the evidence shows.
Will excessively taxing or eliminating share buybacks lead to higher wages or increased income for non-investors? The answer is ‘no.’
Argument #3: Companies repurchase shares to inflate stock prices and executive pay.
The Facts: Senator Warren also argued that share repurchases are simply a means to inflate the stock price and, with it, executive pay. But share buybacks are not guaranteed to lead to stock price increases. Managers must be able to identify when their stock is undervalued for the buyback to generate a price increase. More importantly, any increase in stock price is shared by all shareholders — not just managers. Finally, as noted, repurchase programs have a negligible short-run effect on stock prices. It takes over two years for firms announcing repurchase programs to experience a significant effect on their share price. A little “fluff-and-buff” takes skill, patience, and benefits all long-term shareholders — points noted by Buffett.
Argument #4: Buybacks direct money away from most Americans, who are not shareholders.
The Facts: Senators Chuck Schumer and Bernie Sanders added that buybacks redirect money away from workers and “the vast majority of Americans” who are not shareholders. But will excessively taxing or eliminating share buybacks lead to higher wages or increased income for non-investors? The answer is ‘no.’ Increasing the tax rate on buybacks will likely lead firms to shift distributions to dividends or to simply hoard more cash. Increase the tax on both buybacks and dividends, i.e., reduce after-tax stock returns, and shareholders will simply provide less money to companies, leading to less investment, and less economic growth, which will really hurt Americans. While stagnant wage growth and income inequality are serious problems, blaming share buybacks is nothing more than political misdirection.
The bottom line: Buffett’s right.