Phase I: Returning Cash to Shareholders
Phase II: The Future of the American Economy or Rising Stock Prices
Phase III: Wealth disparity, capital abuse, and politics
The stock buyback debate has taken three phases over the years. Phase one began simply with the question, “what is the best way to return cash to shareholders?” Those in favor of dividends made the case that investors favor cash in hand and allow investors to dictate how excess cash is spent, with the underlying message being that most business executives are not skilled at buying back stock in a way that creates value for shareholders. Those in favor of buybacks discussed the tax inefficiency of a dividend.[1]
Phase two started to veer towards the political, asking the question if company executives were buying back shares to increase the price of their company’s stock at the expense of future value creation by sacrificing capital allocation to capital expenditures, including research and development (R&D). Those against buy backs also said that executives were buying back stock in order to improve their EPS, and increase their own compensation as a certain level of EPS is required by some company boards in order for executives to receive their full bonus. Those in favor of buybacks said that even if executives allocate more capital to R&D, that doesn’t necessarily create more value for shareholders. The golden rule of capital allocation is that the investment of capital must create more value in the future than it does today.
The current phase of the buyback debate continues the executive compensation argument, but dives deeper in the social issues such a wealth disparity, corporate abuse, and lack of skin in the game. What started as simple question in the world of finance, has ballooned into an inquisition of capitalism.
As is common with this blog, I will also examine the misalignment of incentives that led to the current phase of the debate. The usual suspects are all here, principle/agent problem, lack of skin in the game, and short-term thinking. I am not going to try to end the debate by declaring an absolute winner. Each situation will have a different answer. What I hope is that after reading this, people will have a better lens to view specific capital allocation scenarios.
Phase I: Returning Cash to Shareholders
Nothing I am about to present is new. Michael Mauboussin already gave people the best way to understand the various methods companies can use to return cash to shareholders. His two pieces are Share Repurchase from All Angles and Distributing Cash to Shareholders. He is one of the greatest investment writers and you should all go read both pieces of research now.[2]
Let’s start with one of the few first principles in finance; shareholder value is created when capital is allocated to investments that will generate returns greater than the companies cost of capital.[3] If a company cannot find investments that will generate risk adjusted returns greater than its cost of capital, and the company isn’t carrying too much debt, then the company can do three things:
- Hoard the cash and wait for opportunities
- Distribute the cash to shareholders via stock buybacks
- Distribute the cash to shareholders via a dividend
Hoarding cash and waiting for attractive investment opportunities to present themselves is a viable option if your shareholders respect you as a capital allocator (Buffett and Henry Singleton). But it can lead to investors discounting the company’s value (see AAPL 2010 – 2012).
The next step is examine if either a dividend to a share buyback program is the appropriate vehicle to return cash to shareholders. To begin its important repeat the golden rule of share buybacks:
“A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.”
Expected value is in the eye of the beholder. Each investor will have a different belief on the expected value of the company. Company management will also have a different view on the expected value of the company as well. With the golden rule as the benchmark as to whether buybacks are good capital allocation decision, there will be shareholders that disagree for various reasons. If they believe that the company is currently overvalued, thus creating a situation where buybacks destroy shareholder value, those investors are welcome to sell their shares. If investors simply prefer a dividend, those investors can sell shares to create their own dividend. But if you are a shareholder, it’s likely you believe that the current market price doesn’t properly reflect the value of the company, so you should appreciate the company deciding to buy back shares.
There are investor who believe that business executive tend to be poor appraisers of their company’s value and buy only when the stock price is rising and stop if the shares are in decline. This can be the case, but there are excellent executives who are able to buy back stock at attractive valuations. The book The Outsiders gives excellent examples of CEO’s who created a lot of shareholder value by repurchasing the company’s stock.
Patrick O’Shaughnessy did some research a few years ago and found companies that repurchase a significant portion of shares (5% or more of shares outstanding in a year,”high-conviction” buybacks) outperformed stocks that were either purchased less than 5% of shares annually or were net issuers of shares.
He found in another report that those companies with high-conviction buyback programs and traded at cheap multiples performed even better. This makes sense as these companies are likely buying stock that the market is undervaluing and thus will generate an attractive return for the company.
Investors also believe executives only buyback shares to boost their company’s earnings per share (EPS) and beat analyst estimates on profitability. It’s important to note that buying back shares will only improve EPS if the stock’s earnings yield (earnings/price) is greater than the after-tax interest rate (given the current level of interest rates, this is not difficult to achieve).
There is also the topic of buying back shares to offset dilution of shares awarded to executives and employees. I will discuss this later in the essay.
Phase II: The Future of the American Economy or Rising Stock Prices
The debate are stock buybacks expanded into the mainstream as economists and reporters began to dig into the amount of money spent on buybacks. The numbers were large and when compared to the amount of money companies were spending on research and development (R&D), the story being told was that executives where putting short-term interests ahead of long-term value creation. This trade-off would not only hurt the respective companies in the long-term, but the American economy might suffer and fall behind rest of the developed world due to its lack of spending on innovation. Larry Fink’s, CEO of BlackRock, commentary on buybacks has usually generated the most attention (see his annual letters to CEOs: here, here, & here).
First, U.S. spending on R&D has been increasing even with companies spending more money on share buybacks as the chart below from Yardini Research show.
Semper Augustus research shows that companies in the S&P 500 have been allocating capital to R&D and capital expenditures at a steady rate over the last 30 years.
J.P. Morgan research also found that companies are continuing to invest in R&D along with increasing buy backs.
As a final measure to show that share buybacks are not out of control, the average payout ratio (or shareholder yield) was not materially different in 2013 as it was in 1982.
It is important to note that the United States’ economy and its largest companies are becoming more asset light and less capital intensive than 30 years ago. The nature of asset light business generally require less reinvestment to maintain current output and have higher gross margins, thus generating more free cash flow. It is those industries (financials & information technology) that are generally more asset light and less capital intensive than most industries, that are buying back the most shares.
One other note to make before moving on to Phase III of the buyback debate, the increase investment in venture capital. Pitchbook data shows the tremendous increase in in investment in venture capital.
So not only is capital expenditures increasing in the public markets, it is increasing in the private markets as well.
Phase III: Wealth disparity, capital abuse, and politics
The current phase of the buyback depart is the most complicated. The debate has expanded beyond shareholder return and capital expenditures into wealth disparity, corporate abuse, principle/agent problems, and compensation. Before we dive into the issues, its best to start with a little history.
This is not the first time our country has had an open debate about wealth inequality and executive compensation. In 1993, President Bill Clinton signed into law a rule that capped the tax deduction of CEO pay at one million dollars. At the time, similar to now, people were upset at the amount of money CEOs were being paid and found it unfair that companies were able to use executive pay as a tax deduction. The one million dollar cap excluded any compensation that was tied to the CEO’s performance, which is decided by the board of directors compensation committee (this is important to remember for later on). From 1992 to 2000, average compensation for a S&P 500 CEO jumped from four million dollars a year to nineteen million dollars a year. Much of this increase in compensation came in the form of stock options. The rise of stock options was due to the Financial Accounting and Standards Board (FASB) Statement 123 (FAS 123). Essentially, FAS 123 allowed companies to avoid expensing the options that were being given to the CEO as part of the compensation package. As Chris Bloomstran explains:
Under FAS 123 and APB 25, companies avoided expensing option grants like the plague. A company would have to record the “intrinsic value” of an option grant as an expense, but the accounting profession deemed the value of a long-dated option where the strike price matched the market price to be zero, an insane conclusion. Topping the insanity, at exercise, now cashless to the employee, companies could claim a tax deduction representing the difference between the employee’s strike price and the market price at exercise. In effect, taxpayers footed part of the bill to companies who were making CEO’s and their posse rich beyond belief. Because of the lack of expense from an accounting perspective, the dilution that came from share issuance to employees was being done at less than zero on the income statement.
This rule was later revised by FASB in 2004 and begins the transition in compensation from stock options as the main source of compensation to restricted share units (RSU’s). Chris Bloomstran continues:
In late 2004, despite wailing and histrionics emanating from Silicon Valley, FASB released an amendment, FAS 123(r), now called ASC 718, that finally required companies to run the expense of issuing stock options through the P&L, albeit over a phased in period. At this point, fresh off the memory of the nasty 2000 to 2002 bear that spared nary a tech investor, the clamor for option shares waned, for the bear demonstrated that, yes, Martha, stocks can go down. As such, CEO’s, their executives, their boards and their good friends the compensation consultants, the junkies of the dilution trade, decided that to de-risk the chance of losing money, we ought transition from options to restricted share units (RSU’s). If granting options was now an expense, better to eliminate the downside to the employee and just get shares outright, also an expense to the issuing company and only with the strings of a vesting schedule. The degree of dilution was now more transparent, and expensive to the issuing company.
A significant reason why companies are spending so much on stock buybacks is to offset the dilution of employees and executives exercising stock options and vesting RSU’s.
This is the part where the buyback debate turns political. Companies are buying back billions of dollars worth of shares to offset the dilution of stock compensation to both executives and employees. And because stock compensation has moved from options to RSU’s, shareholders are frustrated that executives are less aligned with shareholders than they previously were with stock options. Options require a buy in at the price they are issued, RSU’s are simply given to the employee/executive, no buy in is required. Here is Bill Gurley:
First of all, employees don’t hold RSUs, and if you talk to any compensation executive, board member, or CFO about the companies you’re investing in that use RSUs, they will tell you some number close to 97 percent of RSUs are sold on the vest date. So they’re not a form of stock ownership. They’re a form of cash compensation. No one’s holding them, and that’s huge because options were a form of stock ownership and aligned incentives.
While on the surface, it looks like RSU’s are aligning the incentives of executives and shareholders, in reality that is not the case. Not only are RSU’s not helping to align the incentives of shareholders and executives, its decreases the “skin in the game” executives need to have. RSU’s are basically cash compensation, options require purchase at the price they are granted. That difference changes behavior. Here is Bill Gurley again:
Thirdly, we talked about options maybe creating incentive for too much risk-seeking. I think RSUs create too much incentive for super-conservative executive behavior, and my mind really understood this when I was recruiting an executive into one of our startups, and I was competing with a large public company. I sat down with the executive and said, “Well, show me what package they’re offering you at the other company,” and he had built a spreadsheet, and he had put in all these different things and the RSU package they had given him. I said, “Well, what’s this?” And he goes, “Oh, I’m just assuming the stock’s flat for the next four years.” So he was accepting a job, thinking about the compensation. He had already decided he didn’t care if the stock moved or not. For me, that’s just not what you want. I mean you can hold debt if you want that kind of return.
It is the job of the Board of Directors to oversee a company’s executive team to make sure their actions align with the shareholders. Unfortunately, director compensation has clouded their ability to perform their most basic duty. This is an issue Warren Buffett addressed in his 2019 annual letter to shareholders.
Over the years, board “independence” has become a new area of emphasis. One key point relating to this topic, though, is almost invariably overlooked: Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year.
He continues later in the letter…
Despite the illogic of it all, the director for whom fees are important – indeed, craved – is almost universally classified as “independent” while many directors possessing fortunes very substantially linked to the welfare of the corporation are deemed lacking in independence. Not long ago, I looked at the proxy material of a large American company and found that eight directors had never purchased a share of the company’s stock using their own money. (They, of course, had received grants of stock as a supplement to their generous cash compensation.) This particular company had long been a laggard, but the directors were doing wonderfully. Paid-with-my-own-money ownership, of course, does not create wisdom or ensure business smarts. Nevertheless, I feel better when directors of our portfolio companies have had the experience of purchasing shares with their savings, rather than simply having been the recipients of grants.
Shareholders have been left to fend for themselves as they fight excess executive compensation. There are plenty of companies where the executive pay is quite large, but the shareholders are happy to pay them rather than lose the CEO to a higher paying competitor (Tim Cook, Satya Nadella, Jamie Diamond). But the way this compensation is made can be improved.
Executives running billion dollar companies should be paid well. But the level of compensation and how that compensation is made needs to change. Removing RSU’s and reverting back to stock options would be a step in the right direction. Ideally an executive and/or the members of the Board of Directors would have to use a certain percentage of their compensation/net worth to purchase their company’s stock, but that might be too optimistic at this point. Incentive pay should be geared toward goals executives can control (ROIC, operating margins, cash flow growth) and not stock price performance. These items should also be measured over several years, not just a single year. Compensation is a tricky topic and its probably impossible to configure one optimal compensation plan. Unfortunately, this all might be pie in the sky thinking. I’ll let Bill Gurley take us out…
The problem in Silicon Valley that you have, and maybe it’s a problem with compensation in general, is it’s hard to go backwards. It kind of only goes forwards. [continues later on] You can’t choose not to play. If you do, you yield the field and you lose all the customers. The same thing is happening with this compensation issue. I could be idealistic and try and have a ten-year option period, and I might not hire anybody in Silicon Valley.
[1] Dividends are taxed at a rate of 20%. Those in favor of buybacks would rather see the share price of the company increase rather than pay taxes every year on dividends. The argument continued that if a shareholder needed income, she could create her own dividend by selling shares and still be taxed at the same rate, as long as the shares that were sold had been owned for at least a year to avoid short-term capitals gains tax of up to 37%
[2] If you don’t come back either because you have gone down the Mauboussin rabbit hole or you have come to the Tren Griffin conclusion on my writing, I totally understand. No harm, no foul.
[3] Not getting into the cost of capital calculation debate. I am triggering enough people as it is discussing the merits and pitfalls of stock buybacks.
The views expressed are my own. They have not been reviewed or approved by my employer. Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. Please read my disclosure page.
