What's up with Stock BuyBacks

Share Buyback, widening income inequality and Covid package

The stock repurchase is getting extreme reactions from pundits. Here is Chamath Palihapitiya arguing against it.

Even, Donald Trump is against stock repurchase now. Imagine how bad it must have gotten that it is now out of favor from a politician who supported it earlier.

Read along to learn what is going on here.

Basics

A company sitting on cash has three-way to spend the cash:

1. Funnel the money back in the growth of the company. Re-invest the money in the business or fund a new business line. For growth stages companies, this is the way to go. However, traditionally, established companies have preferred to pay some money back to shareholders as a dividend payment.
2. Dividend Payment: Companies distribute some profit — cash — back to shareholders. After all who else, if not a profit-making machine, will reward its shareholders with recurrent cash payments. By the way, in general, share prices do go down after dividend payment. Important to note, considering, stock buyback, our third pay to spend the cash, sends the price soaring.
3. Stock/Share repurchase: With cash in hand companies buy their share from the market. The number of outstanding shares goes down. As a result, share prices go up. In fact, more often than not, even news of share repurchase sends the price soaring

Now that we know that there are three different ways companies can spend the cash, notice how companies are showing preference towards share repurchase in the last decade in the below chart. Unfortunately, buybacks are high when the prices are high!

The ulterior motive behind share repurchase

1. The cash transfer with dividend payment is not a tax event, but buyback is. Companies are expected to maximize shareholder’s interest, so let’s not pick on this. However, if the growth is bought from tax money, directly or indirectly, taxpayers have the right to be pissed off.
2. Impact on EPS: With share repurchase, EPS ( earning per share) goes up. The numerator of EPS, the earning of the company, stays the same, however, the denominator, the count of outstanding shares, goes down. On the surface, it looks like the company is doing great (Read Chamath’s tweet on IBM at the beginning of the post). The fact is, the EPS is up, not because of growing earning, but because of share buybacks. There is one more catch here, and it leads us to our 3rd point.
3. Equity is a big part of the salaries of senior executives. For top-level executives, the bonus component of the salary is contingent on EPS. With share buybacks, companies are able to artificially inflate EPS and thus make sure that senior executive s — the guys behind buybacks — draw a handsome bonus. Moreover, It also takes the shares prices up, thereby increasing the equity component of their salary. Now, to understand why the main street should be mad about it, continue to the 4th point.
4. Cheap loans: Since the financial crisis, the Fed kept the interest rate low to fuel the economy. The expectation was that companies would get loans to grow their business, and it will, in turn, grow the economy and GDP. However, this is not what happened. In fact, it led to an increase in buybacks. The low-interest-rate loans got funneled into buybacks. Low interest, rather than helping the economy, was helping those folks who own stocks.

Final thoughts

Buyback reminds me of an incident that only now I’m able to make sense of. I heard a senior executive of a multi-billion dollar public company claiming that he was going to take the share prices fivefold. I was impressed. Naive, I thought he was confident in the vision and the work that the team was doing.

Of course, now, I know the quality of the work was not the only source of his confidence.

Currently, because of the grim outlook of the economy, share buyback is getting shunned by both the government and the media. However, naturally, both will move on to the next big thing once the economy stabilizes.

It is on the main street to educate themselves with the chicanery of wall street otherwise income inequality will continue to get worse.

Reference:

www.yardeni.com/pub/buybackdiv.pdf

www.nytimes.com/2020/03/24/business/coronavirus-stock-buybacks.html

www.theatlantic.com/magazine/archive/2019/08/the-stock-buyback-swindle/592774/