The topic of stock buybacks has garnered additional attention in recent months because of the adoption of the tax reform bill. While much of the rationale for corporate tax cuts emphasized business investment, the outcome so far is heavily skewed (as predicted by most economists) toward share repurchases. In fact, according to JP Morgan, only 17 percent of tax cut gains have found their way into capital investments, while 43 percent of that cash has been distributed to shareholders through dividend payments and stock buyback announcements. Bloomberg predicts fully 60 percent will ultimately go to shareholders. All this on top of a whopping $5.6 trillion in buybacks already announced since 2008.
Christopher A. HopkinsClearly, stock buybacks deserve a closer look.
Most of us understand that shares of corporate stock represent fractional ownership. Public companies have chosen to sell shares of their stock to members of the general public in what is called an initial public offering, or IPO. However, the quantity of public shares is not static, as firms may choose to issue and sell additional shares over time to raise equity capital. This increases the number of shares outstanding and dilutes the value of each shareholder's ownership.
The converse also occurs. Companies may choose to buy back their own stock from current holders. This action, called a stock buyback or share repurchase, reduces the number of shares outstanding in the hands of investors, while distributing capital (cash) to those shareholders choosing to sell their stock. Most often this is conducted in the open market but can also be executed through a voluntary direct appeal direct called a tender offer.
Once the shares are repurchased, they appear on the balance sheet of the corporation (technically classified as "treasury stock"), but no longer represent ownership nor receive dividends. They remain available for reissue (typical), or can be extinguished entirely and deleted (rare).
The repurchase of outstanding stock is not without controversy. Until 1982, the move was considered a form of stock manipulation and therefore prohibited. In that year, the SEC lifted the restriction subject to certain daily volume limits. The practice has exploded since.
One rationale for repurchases is the return of capital to shareholders. If a company holds large cash balances and cannot devise suitable investments, shareholders are inclined to insist that surplus cash be returned to them. Companies hesitate to effect temporary dividend increases that may be rescinded later, and so they turn to buybacks.
In some instances, a company may feel their shares are significantly undervalued and may execute a repurchase as an investment strategy. Buybacks are also utilized when firms wish to adjust their capital structure by replacing some outstanding equity with debt from recent borrowings.
However, much of the impetus for the surge in buybacks is less shareholder-friendly. Executive compensation is usually tied to the performance of the company's stock, and often includes stock options whose value depends upon the stock price. And guess what typically happens to a stock when a company announces a huge purchase of its own shares: the price jumps. Poorly justified buybacks can create short-term gains that enrich management but encumber the company's long-term performance, ultimately destroying shareholder wealth.
U.S. firms spent $519 billion on share repurchases in 2017. Estimates for 2018 run to $800 billion. Collectively, corporations now are the largest single buyers of their own stock, according to Bloomberg. Concerns now are being expressed about the effect these large buys are having on market stability and the potential for exacerbating the next market decline.
Time will tell, but share buybacks are bigger than ever and are here to stay.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.