Blain’s Morning Porridge – July 5th 2023: Stock Buybacks – Shareholders, Stakeholders and Balance
“The great thing about the July 4th holiday is sleeping soundly in the knowledge the Americans aren’t likely to break anything overnight..”
Stock buybacks are a contentious issue – there are times they are the right thing to do, and make sense. Often they do not. The trick is to align them with shareholder value and stakeholders and be aware of the consequences. They should not just be about the stock price!
As you read this Morning’s Porridge I will be slipping the lines on the yacht as She-Who-is-Mrs-Blain, our dog Dinner Jacket Wrigglebottom (DeeJay), and I head off to Bembridge in the 1950s (ie: The Isle of Wight) for a short break. We shall murder lobsters, walk, swim, paddleboard and come back refreshed for next week.
Yesterday we recorded a Shard Lite-bite Podcast with my colleague Jacky Ng – CIO of Shard Capital on the subject of Stock Buybacks. I will post it on Linked-in and The Porridge when its released. Jacky is one of the smartest guys I know…. Considered, rational, thoughtful, and measured… everything I am not. I wanted to pick his mind about the rationale behind stock buybacks.
Buybacks are one of these topics I am generally hostile about – to my mind a buyback demonstrates management has run out of ideas. Jackie is far more considered in his view – there are times when they are most definitely justified, times they are not, and times when they need to be analysed and compared to other options.
Share buybacks are one of the most interesting conundrums in finance. When are companies justified in using the capital they have accumulated to push up the value of their shares by buying back stock in the open market? For a long time US regulators judged them illegal for distorting the price of company shares.
The basis of any investment into a company is to receive a return on investment through dividends, and to expect the management will fulfil their fiduciary duty to owners to maximise the company value through profitable growth and the stock price increasing. It’s called Shareholder Value. Cut the number of shares in circulation, and ceteris paribus, the value of each share rises, although the value of the company stays the same!
Today the market also considers companies also in terms of what they create in terms of Stakeholder value – akin to “sustainable” and “ESG”: remember it’s not just the environment, but also the social contribution of a firm and how well it is governed.
Successful companies that generate profits build up capital. There are only really four things they can really do with that capital:
- Maintain it as a “cash pile”, invest it carefully, and have it ready to spend when market conditions are right for acquisitions, expansion and even reinvention of the company.
- Invest in new plant, factories and capacity to improve earnings, productivity, create new and better products and grow the company profits and market share.
- Use it to pay down debt and deleverage the company. (Remembering any company should utilise debt to optimise its balance sheet.)
- Return cash to investors if it’s the best option – which may occur when investment returns look uncertain or low, and building a cash pile is not necessary.
All these options can meet the goal of maximising the returns to investors – creating shareholder value. Buybacks, which effectively push up the price of a company’s stock, return cash to investors in a highly efficient way – subject only to capital gain taxes if the holder decides to sell. That’s an advantage that could change if legislators and regulators perceive the tax breaks as something that should be blocked and taxed.
For the last 15 years, markets been fuelled by massive gains in stock prices. But these returns are out of synch with economic growth: the US economy grew by 40% from 2009-2022, but the stock market rallied 270%, an imbalance created by financial distortion and the price of money being too low, making stocks look excessively attractive. Prices became even more distorted when companies raised debt to buyback stocks – replacing equity with debt.
My doubts on buyback are due to “Shareholder Value” discussions becoming fixated on maximising the price of the stock rather than the value of the company (the sum of its market share, goodwill, assets and liabilities, etc). Buybacks (which don’t create any new plant, product or productivity gains) have become a key method to push up the stock price – but may actually reduce the firm’s value by making the balance sheet weaker.
Through the 20-teens a vast number of companies borrowed on the financial markets, at ultra-low interest rates, with the intention of leveraging up with debt to buy back their own stock. It was generally accepted as an example of pragmatic markets – there was an arbitrage between the price of money and the price of stock that allowed smart company directors to increase shareholder value by pushing up the stock price with debt. Such moves did little to improve the fundamentals of their businesses, but increased the overall financialisation of the economy!
As interest rates have risen, that debt used to finance buybacks has left some/many of these companies struggling with overleverage and unable to refinance. Some will default – leaving equity investors with zero.
Sometimes a buyback makes serendipitous good sense. Apple has built an enormous cash pile from the profits of its ubiquitous bright-shiny tech. It maintains a $51 bln cash pile (cash and securities) available to seize the moment and make the right acquisition – which could be a rival, crushing a threatening new entrant/challenger, buying a chip maker, a EV firm, a flying-taxi constructor, or whatever, but it’s also been able to maintain its high stock price through its Stock Buyback programme, which has clearly contributed to making Apple the most valuable company on the planet – becoming the first $3 trillion firm earlier this week.
(Never forget, most M&A acquisitions prove dramatically unprofitable with companies overspending to buy competitors which are impossible to integrate – it’s often the fastest way to convert surplus capital to mush.)
The largest companies tend to be the ones with capital to go buyback their own stock. Many are constrained in what they can buy in terms of real assets – with acquisitions often being referred to competition authorities, or new investments in non-ESG projects (for oil and gas companies) being blocked by activist investors, meaning its often just easier to go down the buy-back route. At the moment the grim economic outlook means many firms will hold off investments in plant, and because of inflation, may see the best option to be a buyback.
Apple shows it can be done right, but generally stock buybacks should set investors wondering about just how good the management of the company is, and what their priorities are.
A company with a high level of capital generation from sales, or a large cash pile may make a rational decision that tax-efficient returns to its investors from pushing up its stock price through buybacks will be greater than investing that cash pile in growth in terms new plant, productivity gains or acquisitions. In the case of Apple, that’s an optimisation they’ve made – while keeping some powder dry to invest, with the happy effect of also keeping the stock price high via buybacks. It meets any shareholder value test.
But, management that spends too much time thinking about using its capital for buybacks may be too fixated on the financials rather than the business opportunities around them. If they are more interested in creating “value” by playing the company in the stock markets rather than increasing the company’s fundamentals in terms of market share, new products, raising productivity and building profits, are they really the right management to have in place?
Management that lacks the imagination to keep a company continually evolving, but becomes focused on finance, has generally lost the plot. Even bigger risks exist when management are actively incentivised to boost the stock price and favour buybacks over making the right decisions for the company. Boeing is a great example of how badly it can go wrong.
In the 20 years since Boeing was famously acquired by McDonnell Douglas using Boeing’s cash (a great tale of a merger gone wrong for another day), the world’s once best airplane maker spent $60 billion on buying back its own stock. Once it sold aircraft on the basis of its engineering excellence. Now the C-Suite focused on maximising Shareholder Value, and while doing so feathered their own nests. By negotiating themselves great option schemes and bonuses set relative to the stock price, the management were incentivised to push the stock higher through buybacks. Making planes? Not particularly bothered..
Boeing’s management not only spent all the profits they had accrued from selling planes, but also borrowed from the bond markets to finance buybacks. To show what great managers they were, they also cut costs to the bone, and tuned labour relations within the firm into open warfare – which is a crisis when its engineering quality that matters in the product.
Rather than invest $30 bln developing a successor to the venerable B-737 single aisle jet, the company spent all its capital on buybacks and executive rewards. It decided to stretch the no 60 year old 737 design with bigger more fuel efficient engines (to play to airline ESG concerns), and told the airlines it was the same old plane they were already flying. But it wasn’t. It was fatally unstable, requiring software mash-ups Boeing hid from the airlines and pilots. Two crashes occurred, claiming the lives of 346 passengers and crew members.
Boeing’s stock price collapsed (only saved because it was a critical part of the US military-industrial complex.) After investing $60 bln in buying back its own stock it has zero to show for that investment. The executives all got massively richer. Many have been replaced. None have faced legal consequences thus far. Today Boeing is unable to afford the cost of developing a new green fuel-efficient air liner. It is now left as the clear No 2 plane maker to Airbus.
The lesson from Boeing is simple – that its stock buyback programme and management incentive programmes were not aligned to create shareholder, or stakeholder value, but primarily to benefit the Management who made out like bandits on their stock options. Linking management bonuses to stock price is a bad idea.
My conclusion is there are times when a buy-back is justified, but they have potential consequences…
Back next week with more Porridge
Out of time, and off to the boat…
Strategist – Morning Porridge