Share buybacks' impact on market health requires close evaluation

Share buybacks' impact on market health requires close evaluation
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Corporate share buybacks have been on the rise since the global financial crisis and recently hit a record-high of $178 billion during the first quarter of 2018.

This can be attributed to a range of circumstances, including the tax cuts passed in December of 2017 and the goals of the Trump administration to deregulate businesses. The spike in buybacks is drawing new attention to the practice.

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A buyback normally occurs when a company has excess capital, as has been the case for many firms due to the corporate tax cuts. When executives determine there are limited channels to reinvest cash in the business and generate profit, they often return capital to shareholders through dividends or buybacks.

 

Companies might choose the latter for several perfectly legitimate business reasons, including tax efficiency for investors, buying the stock when it's undervalued or when low interest rates make swapping debt for equity accretive to earnings.

By executing a buyback, a company reduces its number of shares outstanding, causing a boost in reported earnings per share and stock price. The announcement of a buyback alone often sends the stock price up, even if the company never actually engages in open-market activity.

While handing out some extra cash in this manner appears to be a bonus for investors, there is a potential dark side to buybacks. Executives could easily be acting adversely to investor interest. Simply put, the nature of share repurchases allows them to be used as a possible tool for various forms of market manipulation.

For example, there is vague regulation surrounding disclosure that can be used by executives calling for buybacks not because it is the strategic choice for the company but to better facilitate the executive selling his or her own shares and cashing out.

Robert Jackson, who holds the Democratic seat on the Securities and Exchange Commission (SEC), raised concern with this practice, pointing out that if executives believe a buyback would truly drive sustainable growth, “They should want to hold the stock over the long run, not cash it out once a buyback is announced."

However, executives are not required to disclose the motivation behind a buyback. In fact, only 20 firms of the S&P 500 publicly share how they make buyback decisions.

There are no legal requirements for a company to report what earnings per share would be without a buyback, how buybacks affect CEO pay or how successful buybacks have been in the long term.

This “light-touch” regulation allows less accountability from executives and would do little to prevent them from taking personal advantage of share repurchases.

Additionally, the jump in earnings per share and stock price caused by buybacks can create the illusion that a company is doing well despite stagnant or declining real growth.

For example, Procter & Gamble announced in 2017 that its earnings per share increased by 6 percent, when, actual earnings fell by about 0.2 percent since the previous year. The firm had bought back $6.7 billion worth of stock, distorting reported figures.

In another case, Netflix experienced low earnings per share when it went international, despite the fact its revenue was growing. Earnings per share is not an entirely accurate depiction of a company’s health, and its manipulation through buybacks undermines the transparency that investors deserve even further.

Additionally, because executive pay packages are often related to short-term metrics like earnings per share, a CEO might be incentivized to spend excess capital on a buyback for their own benefit rather than reinvestment.

This practice erodes the purpose of the link between pay and performance that is essential for fair executive compensation. As reported in Forbes, former General Electric CEO Jeff Immelt raked in a personal fortune of $21.3 million in 2016, yet the stock price of the company had declined by about 38 percent under Immelt’s leadership.

Immelt’s pay package was closely tied with per-share metrics, which were inflated through massive buybacks. Share buybacks are like a toggle switch that executives can flip whenever needed, without prioritizing or achieving real and sustainable firm growth.

There remains significant debate in the financial services industry over the effects and ethical boundaries of share buybacks and to be fair, there are many investors who are big fans of the practice, particularly short-term, active managers.  

The instant pop in stock prices is hard to argue against for these investors. Yet, the potential long-term impacts of depleting reserves or draining the company’s war chest for new investments and emerging opportunities can be a serious strategic mistake.

The current SEC rules regarding buybacks were last updated in 2003 and offer executives a safe harbor from securities fraud liability under specific buyback conditions but little else in the way of investor protection. 

Commissioner Jackson has proposed a thorough examination of existing rules with an objective of closing any gaps and creating more explicit deterrents to use of buybacks as an earnings manipulation instrument. With buybacks on the rise, it is opportune timing for the new commission.

CFA Institute strongly supports the review and feels the SEC should devote further attention and conduct additional diagnostics on the data around share buybacks to determine if patterns of manipulation or executive compensation abuses are evident. 

Moreover, the CFA Institute believes that there are more efficient ways to return capital to investors when necessary, like special dividends. The combination of outdated laws, lack of transparency and the incentives for EPS “gaming” on several fronts should launch a new awareness of buybacks and how they are being used.  

From an investor protection standpoint, we need to know. 

Kurt Schacht is the managing director for the CFA Institute, a global association of investment professionals. The organization offers the Chartered Financial Analyst designation, the Certificate in Investment Performance Measurement designation and the Investment Foundations Certificate.

The CFA Institute's Cece Moyle contributed to this piece.