This is the first of two articles examining the value of share buybacks amid their diminishing volume over the past two years.
In 2014, when deposits from mutual funds and exchange-traded funds reached $85 billion, S&P 500 companies poured about six times as much capital, a whopping $553 billion, into stock repurchase programs, according to S&P Dow Jones Indices.
Since 2009, these prominent companies have chosen, overall, to become the largest buyers of their own stock rather than invest in new business lines or research-and-development projects.
To many people, this is worrisome. It’s most disturbing to the extent one suspects that executives loaded with stock options are enriching themselves by pumping up share prices with buybacks. In 2015, Sen. Elizabeth Warren called on the Securities and Exchange Commission to investigate whether buying back stock is a market-manipulation tactic that should be forbidden.
However, the market does not pour blessings upon every buyback without judgment. Such discipline makes stock buybacks an effective method of investor payout. Unwanted side effects do exist, but they can be cured.
Note that the market applauded stock repurchases before 2015, but not after. The S&P 500 Buyback Index, which measures the performance of the top 100 stocks with the highest buyback ratios, went up by 256% from March 2009 to the end of 2014, whereas the S&P 500 Index registered only a 154% gain.
But since the beginning of 2015, the S&P 500 Buyback Index has slightly underperformed, gaining 24% while the S&P 500 Index increased by 28%.
Corporate America learns quickly from market trends: total S&P 500 share repurchases topped at $572 billion in 2015 and slid to $536 billion the next year. The tide has clearly turned against stock buybacks, which should partially alleviate the senator’s concern.
How does the collective wisdom of the stock market assess buybacks?
The prototypical statement in a typical stock-buyback announcement says something like, “We don’t see any better investment than in ourselves,” which argues that the stock is so undervalued that buying it back offers better relative value for shareholders than any other viable ventures.
That argument become less persuasive in an environment of climbing stock prices. The subdued share repurchase volume since 2015 suggests that the market’s feedback was well taken; such feedback loops protect shareholder values by discouraging value-destroying buybacks.
Nonetheless, management may ignore the market’s suggestions, especially when their incentive compensation plans are based on earnings per share. In such cases, management is incentivized to carry out a value-destroying buyback, since buybacks always lead to a higher EPS.
One solution is to benchmark executive performance with a buyback-adjusted operating EPS to eliminate the impact of unplanned share repurchases. IBM has adopted this practice in its “Performance Share Unit Program” since 2016.
Investors and regulators should consider this method, since it offers a cure for the side effect of buybacks. After all, stock repurchase is a vital channel of investor payout. Investors can quickly reallocate the capital gain into more promising industries — say, from utilities to robotics — but companies cannot. Buybacks also have tax advantages over dividends, another form of payout to investors.
Instead of debating whether we should ban share repurchases, we should focus on how to exclude the impact of buybacks from executive compensation. It is hoped that, after aggressive investigation of the extent to which executive performance is driven by share repurchases, we can gain cautious trust in our CEOs while holding a firm belief that our stock market will hand the C-suite a fair grade.
Jiakai Chen is an assistant professor of finance at the University of Hawai’i at Mānoa Shidler College of Business.