By Randall Smith 

Share buybacks: Yea or nay?

For investors, one of the big results of the election could wind up being the fate of corporate stock buybacks. The widely used financial tool -- which has been a source of support for the record-setting stock market -- has been attacked by some academics and progressive politicians. Now, those politicians will be in a better position to do something about it.

Buybacks have been a particularly hot issue since 2018 when, under terms of the Trump administration's corporate tax cuts, big U.S. companies repatriated billions of dollars that had been stashed for years in overseas tax havens. In the resulting binge, the dollar value of big companies' repurchases of their own stock shot up 55% to a record $806 billion. Buyback foes complained that such repurchases enriched shareholders, generally wealthier Americans, at the expense of workers, new plants and research, and broader economic development

Buybacks are down about 30% this year, as companies conserve cash to ride out the pandemic. But the issue remains prominent for Democrats who just took the White House and retained the House as they plan their legislative and regulatory agenda.

With that in mind, here is what investors need to know about buybacks -- and why they are controversial.

What is a stock buyback?

It occurs when a company uses some of its cash to repurchase its own shares. Other choices include investing for growth, acquisitions, paying down debt or paying dividends.

Legalized in 1982 by the Reagan administration, buybacks took off after a 1992 tax bill capped corporate tax deductions for top executives' pay at $1 million, but left a loophole for "performance" pay tied to stocks. Now, with stocks and options making up about two-thirds of C-suite pay, many buybacks merely offset new issues to executives and employees.

They are used most heavily by mature tech companies like Apple Inc., Microsoft Corp. and Oracle Corp., while shunned by a small but fierce minority led by Amazon.com Inc. and Netflix Inc. A decade ago, Exxon Mobil Corp. did the most. This year, Berkshire HathawayĆ  Inc. jumped in big with $15.7 billion to shrink a $146 billion cash pile.

A study of 610 companies over three decades by a stock-analysis unit of MSCI Inc. found the most active repurchasers were "older, more established" companies first listed between 1980 and 2001. Many companies begin with "one big idea," and ride through their life cycle without another, says Rene Stulz, a business-school professor at Ohio State University. The result is that as companies get older, they don't need as much cash to invest in new growth initiatives.

MSCI also found that buybacks began moving up steadily from less than 1% of the companies' assets before 1994 to an average of 4.1% for the past five years. The percentage of companies in the S&P 500 doing buybacks has more than doubled to 85% since 1992, according to research by Goldman Sachs.

In the current low-interest-rate environment, many companies have taken on more debt, whose interest cost can be tax-deductible, to buy back shares whose dividends may be more costly. Corporate debt levels at 20-year highs have financed much of the buyback binge.

What are the arguments in favor of buybacks?

Money managers at mutual-fund giants Fidelity Investments and T. Rowe Price Group Inc. say buybacks generally help drive higher stock valuations. Goldman Sachs strategist David Kostin says companies can vary buybacks as earnings fluctuate, while keeping "steady growth in dividends," avoiding a dividend cut that can hurt the stock price.

"Buybacks are really just dividends with a different kind of shell around them," says Ric Marshall, lead author of the MSCI study. "They're just a tool for moving positive cash flow to investors. Most professional investors would say they're happy with them." He added that buybacks may be better for some investors if taxed at capital-gains rates rather than as dividends, which may be taxed at higher ordinary income-tax rates.

Reducing a company's share count via buybacks can increase earnings per share, a key valuation metric. And investors who sell their shares and receive buyback proceeds can redirect the cash to different companies with better growth prospects, including venture-backed startups or initial public offerings.

What are the arguments against?

Critics led by William Lazonick, economics professor emeritus at the University of Massachusetts Lowell, say buybacks starve companies of cash for innovation and worker pay, and favor executives aiming to jack up the stock prices because their compensation is increasingly stock-based.

The buyback trend has become controversial since a 2014 article by Prof. Lazonick in the Harvard Business Review, "Profits Without Prosperity." The S&P 500 companies that had been publicly listed from 2003 through 2012, he found, had spent amounts equal to 54% of their earnings for buybacks and 37% for dividends, leaving "very little for investments in productive capabilities or higher incomes for employees."

Critics say this formulation exaggerates buybacks' impact by implying that funds for research and development and capital spending come solely out of net income, and ignores that much of the buyback spending merely offsets new issues of stock.

Prof. Lazonick also decried rising CEO pay, "mass plant closings" and offshoring "millions of unionized blue-collar jobs." Maximizing shareholder value with buybacks was "predatory value extraction," he said. Such criticism reflects the wider debate over wealth inequality and "shareholder first" capitalism.

If nothing else, the critics argue that cutting the number of shares outstanding can help executives hit earnings-per-share targets; 49% of big companies link executive pay to EPS.

The MSCI study found that as buybacks soared since 1988, dividends held relatively steady at around 2% of assets. But capital spending has fallen from 7.4% in the 1990s to 4% in the past five years. Spending for R&D also has dropped, from 3% to 2.3%.

That supports the notion that buybacks may detract from spending for growth. However, MSCI found buybacks haven't hurt 10-year capital returns at most companies. Analysts link some of the drop in capital spending for physical facilities to the rise of tech companies, many of which are "capital light," investing in software development versus hardware or manufacturing.

Where do political parties stand?

The political push to curtail buybacks comes mainly from progressive Democrats.

For instance, last year, Sen. Chuck Schumer (D., N.Y.) joined Vermont progressive Bernie Sanders in urging that companies be required to address their workers' needs, including pay and benefits, before planning buybacks. A House subcommittee held a hearing on buyback limits, and the Senate convened a panel led by Prof. Lazonick.

Sen. Elizabeth Warren (D., Mass.) also backed limits during her presidential campaign. Another Senate Democrat, Sherrod Brown of Ohio, also introduced a bill in July 2019 to require companies to give bonuses to employees tied to the value of their buybacks and dividend increases.

"Buybacks suppress wages, drive income and wealth inequality" and allow "speculators to extract value from public companies," Sen. Tammy Baldwin (D., Wis.) said last year in re-introducing her Reward Work Act, which would ban open-market buybacks and require employee board seats. The bill didn't move out of committee.

Some Republicans support milder measures. For instance, Sen. Marco Rubio (R., Fla.) wrote in the Atlantic in late 2018 that stocks sold in corporate buybacks should be taxed at the same rate as dividends.

But Republican Trey Hollingsworth of Indiana at the House hearing called the issue of buybacks versus worker pay a "fake choice," saying wages are set by workforce supply and demand, and buybacks are "separate decisions."

What happens now?

With Democrats in the White House, "this is an issue that's going to be on the table" if they also take the Senate, says Tom Quaadman, head of the center for capital-markets competitiveness at the U.S. Chamber of Commerce. Legislation is less likely if Republicans hold the Senate after two Georgia runoffs in January.

But a Democratic-led SEC could enact tougher disclosure requirements by itself. During the campaign, President-elect Joe Biden criticized buybacks and expressed support for tighter regulatory supervision -- but not a progressive Baldwin-style ban nor Schumer-Sanders overhauls.

The Council of Institutional Investors, for example, has urged disclosure of how buyback plans might affect executive compensation, and faster two-day reporting on executions. A ban might not pass the Senate even if Democrats win a majority because most legislation requires 60 votes.

Should investors care? Buybacks executed by Goldman Sachs clients accounted for 4.1% of all their stocks' buy orders in 2017-19, Goldman says. So banning or limiting them could hit the size of 401(k) nest eggs, although estimates vary of any possible impact.

Mr. Smith, a former financial reporter for The Wall Street Journal, is a writer in New York. He can be reached at reports@wsj.com.

 

(END) Dow Jones Newswires

December 05, 2020 11:46 ET (16:46 GMT)

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