Share buybacks: Robbing Peter to pay Paul
Share buybacks artificially inflate executive pay and disguise its ultimate cost to businesses.
General Motors announced a $5 billion share buyback in March, adding to the $2 trillion of stock repurchases that have taken place since 2009. As firms have hoarded cash since the financial crisis, it seems that the only kind of investment that they are prepared to make is in their own stock.
According to Bloomberg and S&P Dow Jones Indices, S&P 500 constituents spent $914 billion on share buybacks and dividends in 2014, 95% of earnings. Indeed, the net change in capital stock (share issuance minus share buybacks) in the S&P hit negative $372 billion in 2014, up a third from 2013. In 2009 it stood at positive $14 billion.
Writing in the Harvard Business Review last September, William Lazonick, professor of economics at the University of Massachusetts Lowell, pointed out that, between 2003 and 2012, S&P 500 firms used 54% of earnings, or $2.4 trillion, to buy back stock while only spending 37% on dividends. S&P 500 firms spent $565 billion on stock buybacks in 2014. According to Barclays, corporates now allocate more than 30% of cash flow to buybacks – double the amount in 2002. Capital spending has fallen to 40% from 50% of cash flow over the same period.
The banking sector is far from immune from this trend. The first thing that many US banks did after passing the Fed’s most recent stress tests at the beginning of March was to boost dividends and announce share buybacks: Citigroup will buy back up to $7.8 billion in stock, JPMorgan Chase will buy back $6.4 billion, Morgan Stanley up to $3.1 billion in shares and BNY Mellon $3.1 billion by March 2016. Bank of America Merrill Lynch, which only received a conditional stress tests pass, will still buy back $4 billion in stock by the second quarter of 2016.
Firms argue they have to adopt such strategies due to the talent war raging in the technology sector
There are many reasons why this growth in buybacks is worrying. Many, like GM’s, are the result of shareholder activist shakedowns where the motivation behind the move is abundantly clear. What is more opaque, however, is the impact of executive compensation on buyback activity. Stock options make up the majority of executive pay and buybacks drive up stock prices putting options in the money. Lazonick argues, therefore, that firms are engaged in what is, while entirely legal, effectively stock price manipulation.
Buybacks promote net disinvestment and runaway executive compensation rather than creating value for shareholders. According to the Economic Policy Institute, average CEO compensation, inflation-adjusted, increased 937% from 1978 to 2013 and much of the blame for this can be laid at the share buyback’s door.
In the 12 months to August 2014 Oracle Corp spent a net $6.15 billion, or 3.4% of its market capitalization, on buying back shares. However, only $4.87 billion of this was used to reduce the number of shares in issue; the remaining $1.28 billion was spent soaking up the effect of stock options. A group of investors has been campaigning for years over executive pay at Oracle. Larry Ellison received compensation of $67 million last year despite having stepped aside as CEO to become executive chairman.
By buying back shares with one hand and giving them to employees with the other firms are disguising their true compensation costs. Microsoft bought back shares worth $6.1 billion in the year to June 2014, equivalent to over 2% of its average market capitalization over that period. But its share count only fell 1%, with the 1% balance, or $3.2 billion, given to employees. This is equal to 10% of the firm’s operating expenses. According to Lombard Odier, while Microsoft reported an increase of 3% in its operating income over the last three full years, if the money that employees and management received via options and following buybacks was expensed, operating income would actually be down 7%.
Firms such as Oracle and Microsoft argue that they have to adopt such strategies due to the talent war raging in the technology sector. But by destroying capital investment to inflate executive pay and stoke stock prices, share buybacks will ultimately prove a damaging catalyst of the recent equity bull run.