NRPLUS MEMBER ARTICLE B oeing bought back stock at $400 a share in 2018, and now, two years later, finds itself in cash-flow difficulties with its share price hovering around $120. This is obviously bad for shareholders, but, even given the fact that the current pandemic is a genuinely exceptional event, such predicaments have a way of recurring every business cycle. While stock buybacks benefit top management with stock options, they tend to be unhelpful to ordinary shareholders and are not that great for the economy either. I am generally opposed to government intervention in the marketplace, but there are exceptions, and this should be one of them: Stock buybacks should be outlawed — with one, limited exception — as they were before 1982.
Before then, stock buybacks were prohibited by the SEC, as they were thought to give an unfair advantage to company insiders and the well-connected. The only way a company could buy back its stock was through a public tender offer made available to all shareholders and advertised in the press, with offer documents mailed to every shareholder. Since that process was expensive and ran the risk of raising difficult questions at a shareholders’ meeting, it was undertaken rarely.
The SEC’s pre-1982 view of stock buybacks was correct. If a buyback offer is not extended to all shareholders, it provides an advantage to the firm’s insiders and those with connections to the firm. Following the scandals of the late 1920s, this was regarded as unacceptable. It is true that the ability to trace insider trading is much greater today than it was in 1982, let alone 1929, but the potential for abuse still exists. And what we have seen since 1982 is that the unfair advantage buybacks may give is by no means the only problem with the practice.
In 1982, the SEC issued Rule 10b-18, permitting companies to buy back their stock without making a full public offer. This rule was the result of intensive lobbying by CEOs and a general (and very welcome) spirit of de-regulation among the SEC commissioners appointed by the then-young Reagan administration. It also had a certain economic logic: Stock prices had declined by 75 percent in real terms since 1966, and were at real-terms levels not seen since the late 1940s.
Hence, stock buybacks in the early 1980s often represented good economic value for shareholders; it could be argued that shareholders as a whole would benefit from buybacks at such low prices. If a company’s shares were trading at 50 percent of net asset value, a stock buyback would increase the net assets per share available to other shareholders, and probably their earnings per share also. But that hasn’t been the case for decades now; it didn’t hold true even at the nadir of the 2007–09 bear market.
During the 1980s, because few senior executives were given large grants of stock options, and hence there was no special benefit to management from aggressive stock buybacks, the practice remained rare. This changed with one of Congress’s more foolish tax “reforms”: In 1993, lawmakers, indulging in some class warfare, decreed that pay above $1 million for a company’s most senior executives would no longer be tax deductible at the corporate level, though “incentive” pay — including stock options and performance-related bonuses — was excluded from this new deductibility cap.
The result was a ramping up of “incentive pay” and especially incentive stock options for top executives. This coincided with the massive run-up in stock prices in the late 1990s, goosed by the Fed’s decision to loosen monetary policies after 1995. Executives, being paid more and more in stock options, quickly came to notice that stock buybacks increased the value of their options, whereas cash dividends merely gave money away to the little people who owned shares. So was born a massive conflict between top management and ordinary shareholders that has continued to this day, with top management favoring a “return” of capital via share buybacks over higher (or, sometimes, any) dividends.
In the cheap-money era that started in 2010, the volume of stock buybacks has exploded; stock buybacks by S&P 500 companies totaled $806 billion in 2018 and $710 billion in 2019. This remunerates top management figures like entrepreneurs, rather than the hired hands of the shareholders that they are. Of course, it’s good if they think entrepreneurially, but they should never forget that it is their job to enrich the shareholders for whom they work — or are supposed to work.
In a world that uses discounted cash flow to evaluate investment projects, stock buybacks also kill capital investment. They are treated as having the same return as the company’s return on equity, so they look attractive compared with new projects, which may carry a lower-than-average return. But there are two flaws in this calculation. First, if a stock has a return of 12 percent on book equity, and is trading at three times net asset value, then the true return of a buyback is not 12 percent per annum but 4 percent per annum, because the repurchase only eliminates one third of the shares it would eliminate if it were carried out at book value. As price-to-earnings ratios and price-to-book-value ratios have increased, the effect of stock buybacks on capital investment has become more severe. Looked at that way, it is fortunate that any capital investments beyond the simplest, most short-term projects got started at all in 2018–19.
The current downturn has brought into focus a further problem with stock buybacks: They de-capitalize companies in bull markets, then require either shareholders or taxpayers to re-capitalize the same companies in a downturn. Boeing, for example, has no net worth at all, which is absurd for a company in its highly cyclical business.
Michael Milken may have a checkered past, but there is no sensible argument to be made against him on this point:
The simple rule of thumb is that risk in capital structure should vary inversely with volatility and risk in the basic business. To paraphrase the late Harold Geneen of ITT, you can make a lot of mistakes in business, but you can’t run out of cash. For some companies, even a dollar of debt is too much. This was as true for some airline, aerospace and technology companies of the late 1960s as it was of telecommunications, networking and Internet companies of the late 1990s.
The excessive volume of stock buybacks in this business cycle has created a dangerous situation. It is not clear how well capitalism can operate without capital, but it’s safe to say it can’t operate very well.
From top executives’ point of view, this is fine — they make huge amounts of money on their stock options as stock prices soar, then maybe miss out for a year but get to re-set the exercise price on their options at the bottom of the market. But for ordinary shareholders, stock buybacks in a cyclical economy are a nightmare. If, as is likely, Boeing needs to issue more shares, its shareholders will sell for $120 an item that they previously bought back for $400. Management will get rich, but shareholders will not.
Dividends may come with tax disadvantages compared with buybacks, but they are the lifeblood of investment, and I would resist to my last breath any regulator who attempted to eliminate them, even in difficult economic times like these. Stock buybacks are very different, prone to outrageous abuse and incentivizing executives to enrich themselves at shareholders’ expense. The law should be returned to what it was before 1982.