
Stock buybacks are dangerous for the economy - peer2pay
http://feeds.hbr.org/~r/harvardbusiness/~3/6jA8uy6spIQ/why-stock-buybacks-are-dangerous-for-the-economy
======
crazygringo
> _Taking on debt to finance buybacks, however, is bad management, given that
> no revenue-generating investments are made that can allow the company to pay
> off the debt._

This seems to be the crux of the article, and it appears to be completely
unsubstantiated.

First of all, this article isn't about just stock buybacks -- the argument of
the article applies broadly to dividends just as much, save for minor details.

The point the article is making is that profits ought to be reinvested rather
than paid out. But _obviously_ mature firms often can't find ways to reliably
re-invest. They don't _need_ to grow any further, nor should they. So
investors _want_ them not to re-invest, and throw off dividends or buybacks
instead. This way _investors_ can fund the next generation of companies.

And taking on debt to do it isn't inherently irresponsible. In fact, it's just
a wise financial decision when interest rates are low. New revenue streams
aren't required to be generated -- it's just shifting a subset of future
revenue to the present.

So I really don't get this article at all.

~~~
gbasin
I used to also agree that all the arguments against buybacks apply to
dividends, but I've since changed my mind. On the surface level, they are
identical → cash is transferred from company to shareholders.

But the way the cash is transferred matters, and it has second order effects.
Specifically, as it impacts stock options.

Executives tend to be compensated with options. The more the stock goes up,
the richer they get. Distributing $X in dividends should provide an equal
total return to the average shareholder as spending $X on a buyback, but that
buyback will do it by pushing up the share price.

As the share price goes up more and more, execs with options have
disproportionately more to gain than the average shareholder. They have a
leveraged exposure to the price!

~~~
fountainofage
Could you help me in understanding this? In my head if dividends are paid out,
wouldn't this drive the stock price up the same as if a buyback happened? Or
is this some sort of market inefficiency / irrationality where the market is
rewarding stock purchase volume rather than just looking at the total expected
value of the company?

Edit: sorry about that, I get it now after thinking through it more.

Let's say the stock is truly worth $100 (assuming we could figure that out).
Then if the company does buybacks, the stock trades at $100 - great for the
executive with stock options. However, if the company pays dividends, then the
stock price is reduced by the expected value of those dividends. So total
expected value is the same, and long term executive comp is the same because
they get the dividends as well, but short term they would prefer the buyback
because of the higher stock price. They only benefit the same from dividends
if they have a long term view.

~~~
Ntrails
There are 100 shares in the market I have $100 in cash, and $100 of Assets. My
Company is worth $200

If I pay a $1 ps dividend, then the share price should halve, and the share
owners get $1 each.

If I buy back 50 shares, at $2 each, there will be 50 shares left at a value
of $2 each. But now my earnings/share goes up as if by magic, and my options
are worth more than in the dividend case.

Also capgains vs income tax yada yada

~~~
appleiigs
> But now my earnings/share goes up as if by magic, and my options are worth
> more than in the dividend case.

That's not correct. The EPS increase is offset by reduction in company value
due to less cash. [https://business.financialpost.com/opinion/stock-buybacks-
ar...](https://business.financialpost.com/opinion/stock-buybacks-are-no-
disease-heres-how-they-really-work)

~~~
Ntrails
EPS does go up by magic, since it is earnings (not value) divided by shares
(which have halved in number).

The options bit is a slight fiddle, although empirical evidence supports it.

------
AnthonyMouse
High corporate debt isn't caused by buybacks, it's caused by low interest
rates. Low interest rates _cause_ buybacks because it becomes more attractive
to raise capital through borrowing than selling shares.

It's the same reason both consumer and government debt are also high. But
anybody who thinks now is the time for higher interest rates is a bit
confused.

If anything now is the time to print a bunch of new money to counteract the
existing deflationary forces caused by the coronavirus, which in the long term
is what allows interest rates to rise, since once the deflationary forces wane
the printed money would start to cause inflation which could be counteracted
by at that point raising interest rates.

~~~
magicnubs
> now is the time to print a bunch of new money

I'm curious as to whether the money would ever make it into the hands of the
average consumer (which is where I'm assuming it needs to go to actually cause
an increase in inflation, considering how consumption-heavy our GDP is, but
correct me if I'm wrong!) There have been recent calls for the government to
distribute money to prop up demand, but won't banks lobby politically against
this sort of activity? Seems like a lender wouldn't want inflation to actually
increase because that would cause their current lower-interest loans to be
less valuable? One of the oft-cited concerns for continually missing our 2%
symmetric inflation target is that market participants will begin to expect
and plan for low inflation, which has a negative feedback effect on future
inflation. Seems to me like financial institutions are already expecting low
inflation and aren't all that interested in seeing it rise.

~~~
AnthonyMouse
It isn't really mortgage banks that lose out from inflation. The money banks
loan you is created from nothing as a fiction inside their computers and
destroyed again when you pay it back. The only money that continues to exist
is the interest you paid them, which they get to keep.

Low inflation kind of sucks for banks (and investors in general) because it
tends to coincide with low interest rates. When interest rates are low, people
borrow money and invest it, which reduces _real_ returns by increasing
competition to buy securities.

The people who dislike inflation (really, higher interest rates) are the
people doing all the borrowing.

~~~
nrdvana
> The money banks loan you is created from nothing as a fiction inside their
> computers and destroyed again when you pay it back. The only money that
> continues to exist is the interest you paid them, which they get to keep.

Care to cite a link for this? My understanding is that the money they loan you
is physical and real, but the money “held” for savers is a fiction that could
be lost if the bank went under, thus the reason that the federal government
offers FDIC insurance for money deposited in banks, and why the feds are
allowed to dictate interest rates and tell banks what overall percentage of
their holdings they are allowed to loan out.

~~~
AnthonyMouse
[https://www.investopedia.com/articles/investing/022416/why-b...](https://www.investopedia.com/articles/investing/022416/why-
banks-dont-need-your-money-make-loans.asp)

Banks (like everybody) use double entry accounting. When they make a loan,
there are two entries. One is a credit to your account for the amount of the
loan, the other is a debit representing the debt you now owe to the bank. You
borrowed $5000, so you owe the bank $5000 (the loan) and they owe you $5000
(it's in your checking account), which cancel out. Notice that the amount of
cash in their vault hasn't changed at all.

Banks have reserve ratios. They're required to keep a certain amount of their
deposits on hand in case somebody actually wants to withdraw them. (Those just
got set to zero, but they're normally something like 10%.) But as long as
they've satisfied their reserve requirements, they create money from nothing
when they make a loan.

When you pay back the loan, the debt of the loan and the credit in your
deposit account cancel each other out again, they both disappear and the money
that was created is destroyed along with your debt.

~~~
nrdvana
So I think your description is in agreement with mine, but I consider the
first action of the borrower to be withdrawing the money and giving it to e.g.
someone selling a house. If the person selling the house uses the same bank,
then yes the bank really did just create the money for the loan, but if it
wasn’t the same bank then I consider them to have created money for the
previous investors while handing out the real money to a borrower. Mostly a
matter of perception I guess.

------
missedthecue
I'm surprised this came from the HBR. They said only 43% of companies record
R&D expense but almost all buy back stock.

But that's not true. The 43% number is just companies that capitalize R&D on
the balance sheet. All companies must disclose buybacks, but only some
capitalize R&D, (even though they all spend on R&D), so of course it skews the
data.

That's just a poor comparison on HBRs part.

~~~
3pt14159
I'm not surprised. I've never thought HBR had high quality stuff. This
sentence alone is ridiculous:

> Taking on debt to finance buybacks, however, is bad management, given that
> no revenue-generating investments are made that can allow the company to pay
> off the debt.

Not necessarily. Just as debt can be paid back by issuing more shares to raise
capital, debt can be issued to raise money to buy back shares. It depends on
whether management thinks the current valuation is too hot or too cold.

~~~
jsight
I agree, and I think Apple is an example of a company that uses debt in a
perfectly sensible way.

My fear is that these debt fueled buybacks actually create perverse incentives
among options holders who have a lot to gain from short term gains in share
prices.

~~~
airstrike
> My fear is that these debt fueled buybacks actually create perverse
> incentives among options holders who have a lot to gain from short term
> gains in share prices.

Reckless increasing your leverage is a great way to destroy equity value due
not only to increased interest expense but also from the cost of financial
distress which investors price into their models.

Which is not to say companies don't do that – there's definitely a wedge
between what's best for shareholders and what's best for _management_ ¹, but
there's no way around it other than having shareholders run the company
themselves (which comes with its own set of issues)

1\.
[https://en.wikipedia.org/wiki/Agency_cost](https://en.wikipedia.org/wiki/Agency_cost)

------
bsamuels
The point about executive compensation is probably the most poignant.

If you pay an exec team with fixed price stock options, they can run the
company into the ground with debt to issue stock buybacks and do absolutely
nothing to improve the business and increase the value of their stock.

Stock buybacks do have a place though. When you issue stocks, you're doing so
to raise money for the company. You can think of issued stocks as a kind of
debt you've issued that continuously pay interest over time, except the
interest isn't cash or dividends, it's equity in your company as it grows.

If you know your company is in a good place and the stock is undervalued, you
could convert that debt so instead of having to pay equity as interest, you
pay a dollar amount to a bank. But that tool could also be used to
artificially inflate the value of fixed price stock options that may be issued
to execs.

------
ogre_codes
Anytime a company overextends itself financially, it's dangerous for the
company and if lots of companies do it, the economy as a whole. Look at PG&E
underinvesting in infrastructure while paying large dividends, it's the exact
same problem. Companies have become micro-focused on short term returns for
shareholders and lost track of longer term planning and building anti-
fragilility into the company infrastructure.

Buybacks are one of the bigger ways businesses are doing this because buybacks
have significant tax advantages versus dividends. (

So long as management can rely on low interest rates and government bailouts
for big businesses, it's hard to argue it's even a management failure. It's a
failure of our government to set the correct expectations and fiscal policy.

------
ISL
Matt Levine has a rebuttal to this argument today.

Also, buybacks absolutely benefit shareholders that continue to hold. The
supply of shares decreases, often increasing the value of the held shares.

Levine's argument did implicitly point out to me that there are times when
those who don't sell back some of their shares during buybacks are inherently
taking on more forward risk than with dividend stocks; a lesson I'm learning
now the hard way. One lives and learns.

~~~
scott_s
The value increase caused by the buyback tends to disappear in a year or so.
There was a study which found this, but I don’t have a reference on hand.

~~~
jsight
I do not understand why that would happen. Wouldn't they inflate the earnings
per share, resulting in a permanently higher share price (all else being
equal)?

~~~
dlp211
If stock price was actually based on pure fundamental analysis, sure. That is
not at all reality though.

~~~
jsight
After I wrote that, it occurred to me that there is another counterargument.
If cash-on-hand decreases along with the inflation of earnings-per-share, the
business value doesn't really increase.

I have always assumed that shareholders wouldn't take this into account, but
maybe they deserve more credit than I've been giving them.

------
legitster
HBR also has published a few rebuttals of this same argument:
[https://hbr.org/2018/03/are-buybacks-really-shortchanging-
in...](https://hbr.org/2018/03/are-buybacks-really-shortchanging-investment)

I am of the opinion that they are probably pretty neutral overall to the
economy. Their contribution to inequality is more damning of how capital gains
are taxed.

------
throw0101a
Stock buybacks are no different than dividends†: a form of returning capital
to the owners / investors of a company.

The problem is when boards / executives game the system to front-load options
to themselves and other trickery and then cash them out.

†And dividends themselves in turn should be irrelevant to your investing
decisions:

* [https://www.pwlcapital.com/the-irrelevance-of-dividends-stil...](https://www.pwlcapital.com/the-irrelevance-of-dividends-still-a-non-starter/)

~~~
amiga_500
So why not just issue dividends and avoid the downsides?

~~~
throw0101a
> So why not just issue dividends and avoid the downsides?

As another replier pointed out: dividends create a tax event if the shares are
held in a taxable account (in US: not IRA, not 401(k)).

Sometimes people (pensions, trusts) don't want those types of events and would
rather choose when to invoke tax events by selling only when they need to for
income purposes.

~~~
AznHisoka
But so what if it creates a taxable event? Let's put aside what is good for
you in the short-term, for a second.

If a company does buybacks, and even borrows money for them, it might boost
their stock in the short term, but it doesn't make their company better long-
term, because they aren't investing that money into R&D, and it puts them in a
possible cash crunch in the future (ie airlines today).

As a thought experiment, what if instead of the company buying back stock,
it's the US government. What if they decide to spent $500 billion buying 10%
of every stock out there, instead of giving $1000 to every American citizen
b/c of the virus. The first benefits people in the short-term, and doesn't
create a taxable event. The second benefits people in the long-term, but might
be a taxable event.

~~~
travisjungroth
You're comparing buybacks to everything else. The person you were replying to
was just answering why buybacks are now more popular than issuing dividends.
The overwhelming reason is taxes.

~~~
jsight
I think his point is that buybacks should be no more relevant than dividends.
This pop-culture meme that "dividends are irrelevant" is not unique to
dividends at all.

------
mhb
"Boeing, Which Repurchased over $100B in Stock, Downgraded to BBB, Seeks
Bailout"

[https://www.zerohedge.com/markets/boeing-which-
repurchased-o...](https://www.zerohedge.com/markets/boeing-which-repurchased-
over-100bn-stock-downgraded-bbb-seeks-short-term-bailout)

------
fallingfrog
Here’s the thing: if a company has 1 million dollars in cash, and a 2 million
dollar market cap, and they spend the cash buying back 1 million worth of
stock, the total value of the company, including the cash they spent, has
decreased by 1 million dollars and the stock price should therefore not change
at all.

So why should these stock buybacks consistently be boosting the share price?
Either investors are stupid, or the company is _intentionally paying too much
for its own stock_ so that the CEO can get a big bonus.

I know which one sounds more likely to me.

Edit: I suppose there is a third option: maybe the CEOs were assuming the
stock price would rise forever, and were hoping to cash in on the speculative
bubble, which is less fraudulent but more reckless. I don’t know which one is
worse.

~~~
exoque
The stock price should change because the earnings per share will be higher in
the future.

~~~
fallingfrog
But the company is poorer by the same amount as they spent on stocks, which if
the stock price is correct should reduce earnings by the same amount,
canceling out to no change in the stock price.

~~~
exoque
Yes, the market cap of the company is lowered by the amount it spends on the
buy back, however the value per share stays the same. A year later the profit
from the new year is included in the market cap which is divided by a lowet
number of shares. This means the value of a single share is now higher while
the market cap is the same as in the beginning. Or am i missing something?

~~~
fallingfrog
Yes you are, the company has given up a bunch of cash which could have been
used to hire staff, buy capital and so on, so again _if_ the stock price is
correct they have decided to forego some profits due to the buyback, and it
should cancel out.

~~~
exoque
Fair point.

------
magicnubs
Is this part of why stocks have slipped so much? Based on what I know of the
market (what relatively little I know, I keep up with it, but it's not my day
job), I'd have expected most of the volatility from coronavirus to be in the
sectors most heavily affected by low foot-traffic. Instead companies like
Google and Apple are down 30%. I doubt the anyone is seriously expecting
COVID-19 to cause the average of Google's or Apple's profits over the next 20
years to fall by 30%, so it seems the market must have been oversubscribed?
Maybe it still is. The S&P500 is still at a historically relatively high PE of
18.5 and a Schiller CAPE of 23.2, both of which will probably be even higher
after earnings are announced next month.

~~~
AznHisoka
A lot of trading is done via indexes. So if people are bearish, the whole
market ends up tanking. Stocks like Roku and Netflix should actually benefit
from people staying home, but their stock is still going down, because people
are just selling the entire index.

~~~
short_sells_poo
You are correct and this effect is increasing over time. More and more
investment is being done on baskets of stocks as these investments became
accessible through ETFs and traditional managers were not able to beat the
"dumb" indices (there's nothing really dumb about them).

Sure, there are funds like the Vision Fund or boutique stat arb funds who
still trade individual names, but these are absolutely dwarfed by the size of
investments into entire baskets/etfs. The companies in S&P 500 see more
liquidity that the entire rest of the US equities combined. And inside that
500, the top 50 again sees more trading than the entire 450 rest combined.

So what happens when the market sells off? Everything becomes correlated. All
the idiosyncratic effects are overpowered by the overall selling pressure.
There'll be companies hit more than others, but there'll be very few
(basically none) big names that will weather the storm completely unscathed.
This is the effect of being included in the top 1000-2000 companies in the US.
The moment your company gets there, you have to accept that in a crash, your
stock will do the same as everything else.

This behavior also ties back to a broader effect in financial markets, namely
that in a market stress, correlations spike. All stocks fall, bonds tend to
appreciate (hence stocks and bonds become negatively correlated), by
definition, volatility goes up everywhere.

~~~
paganel
> the top 50 again sees more trading than the entire 450 rest combined.

I have no number to substantiate this hunch but I believe that that was one of
the main reasons why Boeing's shares continued to still remain at a reasonable
level even after the MAX debacle, even though under normal circumstances its
shares should have seen at least a 50-60% nose-dive immediately after the
first signs of corporate malfeasance.

But when almost every big pension fund on the planet has to purchase your
shares because it's included in a big index that will never fail of course
that the stock market won't "punish" despicable moves like the one committed
by Boeing.

------
mannykannot
Is a company with cash on hand and low debt at risk of a leveraged buyout,
leading (if it happens) to high debt and a low reserve anyway?

------
acd
Would it be so that stock buy backs amplify the company stock value during
good times? But is the reverse true when there is a down turn in the market?
Ie when there is a market down turn if a company owns its own stock it
amplifies the down movement?

Can someone who understands this better explain how it works?

------
dgudkov
Fascinating. Correct me if I'm getting it wrong:

The Quantitative Easing brought rates down to almost zero for a decade.
Abundant liquidity, low rate loans.

Corporate management use the chance to get cheap money to buy stocks back.
Stock prices go up, the management gets huge payouts. Workers and shareholders
get nothing. Inequality grows. R&D expenses decline.

As stock prices go up, stock indexes soar and we witness (kinda) amazing
market growth (woo-hoo) which is actually pumped up artificially (who cares).

The virus hits the economy. The stock indexes deflate.

The Fed announces another huge round of QE to "inject liquidity", and we now
all know where it will go.

I'm not sure if all this can be better described by "scam" or "corruption".

------
pauljurczak
To underline huge market distorting impact of stock buyback, read this quote
from Goldman Sachs Top of Mind, Issue #77
([https://www.goldmansachs.com/insights/pages/top-of-
mind/buyb...](https://www.goldmansachs.com/insights/pages/top-of-mind/buyback-
realities/report.pdf)):

"Buybacks have been the single largest source of US equity demand each year
since 2010, averaging $421 billion annually. In comparison, during this
period, average annual equity demand from households, mutual funds, pension
funds, and foreign investors was less than $10 billion each."

------
OscarCunningham
Can't companies just take on debt now, to avoid bankruptcy? Lenders should be
eager to lend to them because they know that business will return to normal
after the virus has passed.

------
IanDrake
>When companies do these buybacks, they deprive themselves of the liquidity
that might help them cope when sales and profits decline in an economic
downturn.

No one is depriving themselves of needed liquidity. Liquidity-need is
forecasted, as is the expected IRR for the cash on hand if it were re-invested
into the company. Ultimately, companies decided share holders got the best
return with buybacks.

~~~
pauljurczak
Really? So why they are asking for a bailout now if they had not deprived
themselves of needed liquidity? Have they not noticed the cyclical nature of
economy?

What is happening is executive suite milks the cow to death as fast as
possible, because there no adverse consequences for them. They think they will
be safe in their bunkers in New Zealand when the shit hits the fan.

~~~
IanDrake
Who took on more debt just for stock buyback that is now asking for a bailout?

~~~
pauljurczak
It's not necessarily about taking debt to buyback their stock. It is about
free cash flow. Here are some facts:

"As a group, the six [major US] airlines spent 96% of their free cash flow on
stock buybacks over the past 10 full years through 2019."

"Boeing’s free cash flow for 10 years totaled $58.37 billion, while the
company spent $43.44 billion, or 74% of free cash flow, on stock repurchases."

------
jganetsk
Maybe it's just profitability is dangerous for the economy.

[https://thenextrecession.wordpress.com/category/profitabilit...](https://thenextrecession.wordpress.com/category/profitability/)

------
cornishpixels
> In 2018 alone, even with after-tax profits at record levels because of the
> Republican tax cuts, buybacks by S&P 500 companies reached an astounding 68%
> of net income, with dividends absorbing another 41%.

Uhh... well, that math doesn't check out.

~~~
ascagnel_
It's saying that the S&P 500 companies spent a total of 109% of their income
on buybacks and dividends, intentionally and voluntarily running at a loss to
increase stock prices (vs. running at a loss to grow revenues or something
similar).

------
ortusdux
I would say that the airline industry regrets spending 96% of their free cash
over the ~last decade buybacks, but it looks like they are probably going to
get bailed out...

~~~
jbverschoor
So they can issue back those shares on the market

~~~
AznHisoka
But don't buybacks usually mean they bought back the shares and eliminated
them? It no longer exists. It's not sitting in any account.

~~~
jbverschoor
They can issue new shares if they want.

Also, how come they’re in trouble if everybody paid for their tickets, and
they’re not flying?

~~~
jandrese
Airlines have been issuing refunds. Also, new bookings have fallen off of a
cliff.

~~~
jbverschoor
Interesting

------
s1artibartfast
I would have liked to see the article address the potential advantages of
stock buybacks.

Are companies with greater ownership more resilient to market turbulence? Are
they better positioned to focus on long term growth over short term
performance?

Additionally, it is unclear if these companies were neglecting R&D or had
already exhausted their viable options. If the economy does turn for the
worse, would additional high risk R&D investments still yield returns? Perhaps
they were wise not to park capital in R&D

Last, buybacks allowed a large number of shareholders to cash out while the
market was at an all time high.

~~~
digitaltrees
It’s literally impossible to exhaust R&D Opportunities. The hard part is going
from research to commercialization but the is an almost unlimited amount of
innovation still possible.

~~~
s1artibartfast
There may be near infinite opportunities to invest, but that does not mean
they can be profitable.

Also, if something is a good investment, it doesn't mean it is a good
investment for a given company.

~~~
digitaltrees
That’s true and a good general guide but the current incentives for the
executive team to under invest in long term health of a business and boost
short term profit are overwhelming this rational analysis.

~~~
s1artibartfast
The incentive for the executive team are set by the board and shareholders,
who could easily restructure incentives to favor R&D investment. Whether is
this is good for long term profit will be different from case to case.

I worked at a company where annual goals routinely included invest X billion
on new technology acquisitions. Some of this money sticks and some doesn't.

------
bitxbit
I am shocked how many companies were so thinly spread after ‘08 and the virus
exposed them. We learned absolutely nothing from 2008 (probably because the
govt bailed out everyone). Does capitalism really work when we can’t even
enforce true price discovery?

------
chris123
They're means to transfer wealth to the executives and risk too everyone else.
Simple as that.

