US companies spent $2 trillion buying their own shares –– that’s financial engineering not value creation
Wall Street wants ever increasing quarterly earnings - and corporate buyback schemes help companies deliver that. - Credit: Xinhua/SIPA USA/PA Images   

Corporate buyback – in which companies repurchase their own shares, overwhelmingly on the open market – has been rampant for decades, but was boosted after the financial crash by the availability of cheap credit. And while share repurchases fell 20% last year, President Trump’s tax cuts may give buyback renewed impetus. Just under half of companies who could benefit from the plan by repatriating cash stored abroad say they would use the windfall for share repurchases (buyback was the second most popular option after paying down debt).1 At the heart of the bullish stock-market is the constant stream of buyback funds.

Why do companies want to buy their own shares? Because fewer shares means higher earnings per share (EPS) – the magical measure of corporate success that Wall Street watches. The problem is that it’s all smoke and mirrors, or, as others have dubbed it, “financial engineering”. It is distorting corporate behaviour in ways that are profoundly damaging to America’s long-term economic health. Buyback is the epitome of short-termism, fuelled by corporate greed.

In 2012, pay packages among the top 500 paid executives in US public companies averaged over $30 million, with more than 80% of that linked to stocks and shares.

“Value extraction over value creation”

Between World War II and the late 1970s business focus was largely on value creation – earnings were retained to be reinvested in productive capacity; in physical and human capital. Yes, the aim was to drive further profits, but through real, sustainable growth.

Then, as economist William Lazonick has argued, in the late seventies the “retain-and-reinvest approach” gave way to a “downsize-and-distribute regime”, or, to put it even more starkly, “value extraction over value creation”.2

This was in part the result of a new business management mantra: ‘shareholder value maximisation’, and coincided, unsurprisingly, with large increases in stock-based executive pay (tying CEO interests more closely to those of some shareholders, the ones looking for short-term gains). In 2012, pay packages among the 500 highest paid executives in US public companies averaged over $30 million, with more than 80% of that linked to stocks and shares.3 Increasing share value became the overriding focus of corporate America.

The majority of companies would rather sacrifice longer-term value than miss short-term earnings targets. 80%, for example, would cut discretionary spend such as R&D and maintenance to meet an earnings target.

One study published in 2006, and based on a survey and interviews with chief financial officers, shows this perfectly. The majority of companies would rather sacrifice longer-term value than miss short-term earnings targets. 80%, for example, would cut discretionary spend such as R&D and maintenance to meet an earnings target, and more than half would defer valuable long-run projects for that same reason.4

Wall Street’s hunger for higher and higher quarterly EPS postings had become the priority.

Legalising buyback has real-world costs

It was in 1982 that the Securities and Exchange Commission (SEC) made buyback legal – by amending the 1934 Securities and Exchange Act to provide a “safe harbor” for companies to repurchase shares. This deregulatory move, as Lazonick puts it:

“In essence…legalized stock market manipulation through open-market repurchases.”

Unbelievably, executives can now benefit from ‘insider-trading’. While SEC’s 1982 rule set some parameters for repurchases, disclosing daily buyback activity was not one of them. Company executives can continue to trade based on buyback intelligence unknown to the outside world. Another example of a system rigged in favour of a corporate elite.

Apple is undertaking a $300 billion share repurchasing and dividend programme. Credit: San Jose Mercury News/ABACA/PA Images

Big business has not been shy in making the most of the SEC’s deregulatory gift. Between 2004 and 2013, Exxon Mobil, for example, spent over $200 billion on buybacks, Microsoft and IBM both spent over $100 billion.5 Apple are undertaking a $300 billion share repurchasing and dividend scheme.6 In the fourth quarter of 2015, more than a quarter of S&P 500 companies bought enough of their own shares to push their EPS up by at least 4% on the previous year.7

Imagine the difference that money could have made.

Think for a minute what the $2 trillion spent by S&P 500 companies on buyback during 2010-2015 could have been spent on. Think about the risky, but high-potential projects that weren’t funded. The innovation missed. The skills investment foregone. The jobs that weren’t created. The pay rises that ordinary workers never received (despite soaring executive pay).

Prioritising short-term earnings manipulation over capital investment has big real-world costs – and at a time when global competition demands more, not less, investment in innovation and skills.

Buyback isn’t actually good for shareholders (at least not long-run investors)

And to cap it off, buyback isn’t even working that well for shareholders. McKinsey found that while buyback may boost earnings on paper – back to the smoke and mirrors – it doesn’t improve returns. Based on a sample of 250 non-financial S&P 500 companies McKinsey analysts found no link between share repurchase intensity and total return to shareholders.8 And just three of the ten largest share repurchasers since 2003 have outperformed the S&P 500 Index.9

Think for a minute what the $2 trillion spent by S&P 500 companies on buyback during 2010-2015 could have been spent on. Think about the risky, but high-potential projects that weren’t funded. The innovation missed. The skills investment foregone. The jobs that weren’t created.

In a Harvard Business Review essay last year debunking the ‘shareholder value maximisation’ myth, Joseph Bower and Lynn Paine point out that there’s no single shareholder, there’s a bunch of investors with different objectives – it’s just some shout the louder than others.10

The ‘activist’ view of value creation, they argue, “is more accurately described as value transfer… Nothing has been created.” It leads to “further wealth flowing to sophisticated investors at the expense of ordinary investors and everyone else.” And they too are concerned by the perverse incentives created:

“Rigid adherence to the model by companies uniformly across the economy could easily result in even more pressure for current earnings, less investment in R&D and in people, fewer transformational strategies and innovative business models, and further wealth flowing to sophisticated investors at the expense of ordinary investors and everyone else.”

The temptation to chase the quick buck is trumping real investment – and the eye-watering level of corporate buyback schemes is one of the biggest symptoms. Wall Street hasn’t learnt delayed gratification, so nor has corporate America. But a stock market driven not by value creation through long-term investment, but by financial engineering is fickle. Those short-termist investors and executives should remember that 2007 recorded the highest spend on stock buybacks at $721 billion. And we all know what happened next.

FOOTNOTES
  1. Jeff Cox, ‘Companies have big places for trillions in overseas cash – if tax reform ever happens’, CNBC, 13 July 2017
  2. William Lazonick, ‘Profits Without Prosperity’, Harvard Business Review, September 2014
  3. Ibid
  4. John Graham, Campbell Harvey and Shiva Rajgopal, ‘Value destruction and financial reporting decisions’, Financial Analysts Journal, 2006
  5. .‘The repurchase revolution’, Economist, 12 September 2014
  6. Gina Hall, ‘Apple to sell billions of dollars in bonds to fund share buybacks, dividends’, Silicon Valley Business Journal, 6 November 2017
  7. Lucinda Shen, ‘Here’s what’s keeping the stock market up’, Fortune, 25 April 2016
  8. Obi Ezekoye, Tim Koller, and Ankit Mittal, ‘How share repurchases boost earnings without improving returns’, McKinsey, April 2016
  9. William Lazonick, ‘Profits Without Prosperity’, Harvard Business Review, September 2014
  10. Joseph Bower and Lynn Paine, ‘The error at the heart of corporate leadership’, Harvard Business Review, May-June 2017
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