The Power of Share Buybacks
For several years I have had a recurring argument with fellow analysts on the topic of share buybacks. Do they really benefit shareholders? With share buybacks on the rise, now’s a good time to address that question.
A “share buyback” refers to a company buying back its own shares from the market, which reduces the number of shares outstanding. That, in turn, increases earnings per share and should boost the value of the stock. Share buybacks are a way of returning cash to shareholders.
Share buybacks provide an alternative to dividend increases as a means for companies to return money to shareholders, but share buybacks are more flexible. If you increase the dividend, shareholders will expect the increase to be maintained.
One friend who previously worked for a prominent Democrat senator has insisted that it’s a bad corporate practice for oil companies to buy back their own shares. She argued that they should be using their cash to find new oil, not to buy back shares. Does she have a point?
A Benefit Only for the Wealthy?
Her argument has gained several new advocates since the the Tax Cuts and Jobs Act (TCJA) was passed in late 2017. The centerpiece of the law was a cut in the corporate tax rate from 35% to 21%. Proponents of the law argued that it would spark an investment boom that would lead to higher wages and greater employment.
There was an uptick in business spending following the tax cut, and gross domestic product (GDP) growth has been strong. But the biggest response to the new law was a massive surge in share buybacks. As Anne Marie Knott, one of my colleagues at Forbes magazine, writes:
The dominant company response to the TCJA was stock buybacks. For the first three quarters of 2018, buybacks were $583.4 billion (up up 52.6% from 2017). In contrast, aggregate capital investment increased 8.8% over 2017, while R&D investment growth at US public companies increased 12.5% over 2017 growth.
This news has critics of the tax law claiming that share buybacks enrich the wealthy at the expense of average Americans. U.S. Senator Tammy Baldwin (D-Wis.) said as much: “The surge in corporate buybacks is driving wealth inequality and wage stagnation in our country by hurting long-term economic growth and shared prosperity for workers.”
Why Companies Buy Back Stock
Here’s how I have answered people during my years at ConocoPhillips (NYSE: COP) when we announced a share buyback. We had a significant exploration and production budget. We were searching for oil all over the world, but you have to prioritize opportunities. Other companies are competing for the same opportunities, and you could easily end up overpaying for acreage.
Now, assume that I am the CEO with a pot of money to invest. I will invest it in all the opportunities that I believe are economical. I will also fund my research and development budget at an acceptable level.
But let’s say I have done these things and still find myself with a decent pile of cash. Further, I believe the market is significantly undervaluing my company. It’s a no-brainer in that situation that I will buy back shares.
I am using my cash reserves to increase value for shareholders, and it may be that the best bang for my buck is buying back my own shares.
A Useful Indicator
But is this information useful for investors?
Indeed it is. A 2010 paper from The Johns Hopkins Carey Business School, Long-run Stock Performance Following Stock Repurchases, found strong evidence that companies that buy back shares experience “significant long-term abnormal returns.” In other words, share buyback programs are an indicator that can help investors beat the market.
The paper also explained why previous studies had come to inconclusive results. The abnormal returns were found only in companies that announced buyback programs and then followed through. The announcement sometimes provided a lift in the share price, but it wasn’t sustainable unless the company actually bought back shares.
So which companies are actually buying back shares? This list is quite long, but here is a table of companies that have recently made announcements to buy back at least 10% of their shares since the beginning of this year:
Should you invest in companies that intend share buybacks? It’s a useful criterion, but it shouldn’t be your only one. As always, keep your eye on the long-term horizon and focus on the corporate fundamentals, such as a strong balance sheet and growing earnings.
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