Stock buybacks work when fundamentals don’t matter
An edited version of this blog was originally published by Worth
by Garvin Jabusch
Stock buybacks, sometimes called company share repurchases, aren’t productive. They don’t make a product, provide a sellable service, provide training, invest in research and development, or innovate. They may create wealth, but it is not organic wealth creation, it is a function of artificially limiting the supply of a stock. But the underlying company is not worth more; the buyback has not helped it sell more or better. On the contrary, using profits and other company resources (often debt) to buy shares limits a firm’s ability to innovate, to invest in R&D, to scale production, to better compensate desirable employees, or to do anything else that may augment its intrinsic or book value. With a buyback program, the firm is creating the illusion of value by artificially creating a relative scarcity of shares. But there is a fatal flaw in the logic of share repurchases: for the supply and demand dynamic to raise prices, it takes more than restricting supply, there must also be demand. If a company squanders its resources on buybacks to the point that it is not competitive with its peers, it doesn’t matter how few shares are available, because investors won’t want to own the stock.
So buybacks, apart from near-term benefits to executives who are compensated in company shares and options, are not great builders of value. Buybacks don’t add to the size of a company’s economic pie, they simply deliver a bigger slice of the existing pie to the largest shareholders, usually executives. That being the case, why aren’t more investors avoiding companies overspending on buybacks?
Most stocks today are purchased without any regard for what a company does, what it makes, or how it manages its finances. As a recent cnbc.com article explains, “80% of the stock market is now on autopilot…Passive investments control about 60% of the equity assets, while quantitative funds — those relying on trend-following models instead of fundamental research — now account for 20% of the market share, according to estimates from J.P. Morgan.” Today, the main reason to buy a stock is because it is in an index. Companies understand that, and they know that as long as index funds have to own them, there is demand for their shares, regardless of growth or fundamental value in the underlying business.
In this world, where the demand part of the supply/demand curve is guaranteed, limiting the supply of shares would seem to make sense. Except spending on your own shares instead of on R&D, growth or employee development means you’re not innovating. And, today more than ever, innovation is the clear path to growth, profits and even domination.
On the point of ability to dominate, another danger is the advantage buybacks can give to global competitors. You know what companies spend less on buybacks than US firms? Chinese firms. R&D powerhouse Huawei, for example, is a cooperative (owned by “96,768 employee shareholders”), so they lack even the capacity to engage in buybacks. To a meaningful degree, corporate America’s obsession with spending large portions of retained earnings on their shares rather than on their business is handing a technological advantage to China and other competitors who spend profits more wisely. We’re committing unforced errors. (Recently, though, China has eased regulations limiting buybacks for companies domiciled there, so surely some firms in that country will begin scoring own goals as well.)
Are stock buybacks truly the opposite of creating fundamental value? So much so that before 1982 companies buying back their own shares could be charged with market manipulation. The pervasiveness of buybacks today is not only unwise, but also dangerous. It is part of how systems collapse: if it goes far enough, people can see the lack of underlying value, and will lose faith in ability of markets to reflect underlying worth. As economist Tyler Cowen has written, “without production, value is problematic.”
Combine William Lazonick’s observation (via Sheelah Kolhatkar in the New Yorker) “that, between 2013 and 2019, Boeing spent …forty-three billion dollars on buybacks (a hundred and four per cent of its profits) rather than spending resources to address design flaws in some of its popular jet models,” with the claims of former Boeing engineers (as reported by Bloomberg) that “relentless cost-cutting sacrificed safety,” and you know everything you need to about how pernicious, and even catastrophic, buybacks can be. (Italics added.) Not for nothing, Boeing’s first half sales data, released July 9th, 2019, showed deliveries down 37% from the same period in 2018, demoting the firm to second place, behind Airbus, among the world’s biggest plane makers.
Passive investing is short-circuiting free market economics. Instead of chasing the best, most innovative new ideas, the invisible hand now simply drops money into the S&P 500 (or what have you) without respect to the goods and services, innovation or value creation that a given company represents. When you encounter a company that believes it really has nothing better to do with its money than move it around the different cells of a share ownership spreadsheet, I would suggest what you see there may not represent fundamental long-term value. Perhaps, passive indexing notwithstanding, demand for such companies won’t be there indefinitely. Maybe one day, investors will once again care what a company actually does.
During the time period this blog was written and published, Green Alpha did not hold any company or client assets in shares of Boeing Co (ticker: BA). The companies identified in this blog do not represent all of the securities purchased, sold or recommended for advisory clients. You may request a list of all recommendations made by Green Alpha in the past year by emailing a request to firstname.lastname@example.org. It should not be assumed that the recommendations made in the past or future were or will be profitable, or will equal the performance of the securities cites as examples in this document. Additional important disclosures should be read here https://greenalphaadvisors.com/about-us/legal-disclaimers/