Stock Buybacks: Rewarding Executives Through Rearview Investing
Share repurchases, also referred to as stock buybacks, have recently become a very common way for corporations to spend excess capital. In fact, on June 18, 2014, S&P Dow Jones Indices reported that repurchases and buybacks had climbed by almost 60% in the first quarter of 2014 compared to the same period in 2013. According to the report, the S&P 500 increased buyback expenditures by 29% for the 12 months ending March 2014, to $535 billion from $415 billion over the 12 months prior. While companies often explain that they’re buying back shares presently undervalued on the open market, there are certain additional motivations behind these share repurchases that deserve investor attention.
Indeed, stock buybacks can be a reasonable use of free cash, particularly in circumstances where dividends would be appropriate but the repurchase plan is more tax-efficient for shareholders. These share repurchases enrich shareholders by reducing the number of outstanding shares and boosting the company’s share price. However, a poorly designed management incentive compensation plan can motivate share repurchases that are economically unwarranted for the company but benefit management at the expense of other shareholders. Such share repurchases can reflect attempts by management to artificially boost the company’s earnings per share by reducing the number of shares outstanding, or to offset earnings per share dilution associated with employee stock option programs.
Furthermore, a corporation should repurchase its shares only when its stock is trading below management’s best estimate of value. Conventional wisdom suggests that bear markets would then be an ideal time to repurchase undervalued shares. Yet buybacks rose significantly in 2007 and 2008 just prior to the financial crisis, when companies in the S&P 500 were trading at a P/E ratio of over 25, and declined significantly in 2009, when the market’s P/E sank to 13.
Buybacks were up again in the first quarter of 2014, even though stocks were trading at 20.6 times net earnings in the Russell 3000 at the end of 2013, as opposed to 16.7 times at the end of 2012. These statistics suggest that companies are likely engaging in rearview investing, or repurchasing shares at a time when they are more likely overvalued than undervalued. When share repurchases occur in a bull market and not a bear market, it’s more likely that a company is capitalizing on a wave of price increases instead of buying low based on an analysis of its own fundamentals, or simply acting to counteract dilution from option awards to executives.
Share buybacks can also divert a company’s resources away from investments in research and development, hiring new workers, construction of factories, and other innovation and growth initiatives. However, some companies are also taking advantage of the Federal Reserve’s low interest borrowing rates to conduct buybacks without using the company’s cash flow. If a company is borrowing to repurchase shares when it’s not particularly undervalued, this should serve as a red flag to investors. Also, a buyback will reduce the amount of equity on a company’s balance sheet, increasing leverage and raising the return on equity, but without necessarily increasing profitability. Shareholders should question whether they are investing in financial engineering or in improved operational performance.
It’s also difficult to ignore the effect these share repurchases have on executive pay. The vast majority of compensation earned by CEOs and other senior executives is in the form of stock options and restricted stock, which receive a boost in value along with the holdings of other shareholders. In addition, many CEOs’ bonuses are predicated on improvements in earnings per share, which means that a company can meet its targets simply by virtue of share repurchase. Indeed, if the true intent of a buyback is to return some cash back to shareholders, then bonus formulas should avoid paying out for earnings per share improvements driven solely by the reduction in shares outstanding.
Several of the companies conducting the largest share buybacks so far in 2014 are from the technology sector, a sector well known for bestowing large stock option and restricted stock grants on senior executives. Indeed, companies such as Apple, IBM, Oracle, Cisco Systems and eBay have all bought back a significant number of shares this year. These tech companies could be sending a message to the market that their shares are currently undervalued. However, it’s also quite possible that these companies are simply propping up headline-grabbing earnings per share numbers to look more attractive to investors, or to maintain the value of executives’ outstanding options.