Corporations are hurting. That tends to happen when the global economy shuts down. But recessions happen even without pandemics. Companies now receiving billions in government loans borrowed huge sums of money over the past few years, leaving them ill-prepared to deal with the shock from the coronavirus. Arguing that these companies should have had enough cash on hand to weather an unforeseen economic shutdown, critics have identified a culprit: stock buybacks.
To conduct a stock buyback, a company uses either cash or debt to purchase its shares on the open market and then “retires” those shares, bringing down the total number of shares outstanding in the company. In doing so, firms return earnings to shareholders. The four largest U.S. airlines bought back over $40 billion of their stock since 2012. Observers from the far left to the populist right argue that those share repurchases left companies vulnerable to the current recession. Some trot these numbers out to argue that the government should not provide assistance to companies that bought back stock in the leadup to the pandemic.
On this view, share repurchases are not intrinsically bad, but the risks they carry are. Restricting stock buybacks would decrease risk by forcing companies to retain more cash, the argument goes.
However, a ban on stock buybacks would do nothing to reduce risk-taking, because corporations could still return earnings to shareholders in the form of dividends. At present, executives choose a tax-optimized blend of dividends and share repurchases to pay their investors. Stem the flow of buybacks, and a sizable portion of that cash will simply be redirected toward dividend payments. Redirecting money from buybacks to dividends comes at a cost. Once a company has established a certain dividend payout, management is loath to cut it, because investors see dividends as implicitly guaranteed. Therefore, eliminating share repurchases actually reduces the ability of corporations to retain cash: Dividends are a straitjacket during times of financial stress. (That’s why companies are now going to great lengths to maintain dividend payouts during the pandemic.) Corporations would also remain free to borrow money as they please, subject to roughly the same budget constraints, meaning that their overall leverage would not decrease.
Others go further: Politicians such as Senator Tammy Baldwin (D., Wis.), whose Reward Work Act calls for an outright ban of share repurchases, argue that companies shouldn’t return money to their investors at all. Baldwin, Alexandria Ocasio-Cortez, and others of their ilk claim that stock buybacks come at the expense of investments in new facilities and workforce expansion.
Imagine you’re a greedy corporate executive sitting on $100 million in cash. You want to invest it as profitably as possible in order to maximize the value of your company. If opening new factories and hiring workers will yield substantial profit, then you’ll use your $100 million to open new factories and hire workers. If, however, you run a mature company with relatively few investment opportunities (e.g., a legacy telecom firm), your cash is more profitably invested elsewhere (e.g., a technology startup). Your company could invest in the startup directly, but that would involve opening up an entirely new line of business in which you have little expertise. Instead, you distribute the cash to your shareholders, who proceed to invest that cash in high-growth companies, because they’re greedy and want higher returns on their capital. Your company now looks more attractive to investors because you’ve demonstrated a commitment to paying back shareholders.
If you couldn’t return that money to shareholders, you’d funnel it into relatively unproductive projects, or else just park it in a savings account. The attendant reduction in the supply of capital to the economy would increase borrowing costs for small, growing businesses — reducing overall growth. Hiring would decrease, too, because the low-productivity investments you’d make would lead to fewer employment opportunities than would high-productivity investments elsewhere.
But this is mostly beside the point, because most share repurchases are funded with debt, not cash. Debt-funded buybacks look like nefarious financial engineering: Executives borrow money and move it around without creating anything of tangible value. In fact, they’re simply a mechanism for reducing funding costs, which, incidentally, decreases the flow of money from businesses in the real economy to financial institutions.
Capital comes at a cost: For debt, it’s the interest rate on a loan; for equity, it’s the earnings foregone by selling a piece of a company. If debt provides significantly cheaper funding than equity does, and if a company can afford to pay interest on higher levels of debt, then borrowing money and retiring equity through share repurchases will reduce the firm’s cost of capital. With interest rates at historic lows, it’s no surprise that corporations have increased the relative portion of debt on their balance sheets. If Congress barred corporations from reducing their number of shares outstanding, higher funding costs would represent a deadweight loss.
Because companies use share repurchases primarily to alter their capital structure, they don’t come at the expense of investment. In fact, the airlines now being singled out for recklessly buying back stock have doubled their capital expenditures since 2012, spending roughly twice as much of their earnings on business investment as on disbursements to shareholders.
In the wake of the pandemic, corporations will need to be more thoughtful about “tail risks” — low-probability events with extreme impacts. Investors will likely charge a higher premium to levered firms than they did in the past as they grapple with the implications of unforeseen economic shocks. Firms should also rethink the “just-in-time” supply chains that leave them vulnerable to unexpected events. But preventing companies from buying back their stock will do nothing to shore up balance sheets. Instead, a buyback ban would increase fixed dividends, reducing companies’ discretion in holding cash, while tying up capital in less productive businesses — to the detriment of wages, investment, and consumption.