The buyback battle: a primer

By Robert Samuelson

 

The latest pitched battle between Corporate America and its critics involves stock buybacks: Large companies’ purchases of their own shares on the stock market. The aim is to raise share prices and satisfy investors. But the practice has triggered outrage from critics, who argue that the buybacks discourage productive investment, higher wages and worker retraining. Big business is accused of sacrificing the nation’s future for short-term greed.

Here’s the background.

No one disputes that buybacks — once rare — have soared. In 2018, companies in the Standard & Poor’s index of 500 firms spent a record $753 billion on buybacks, up 40 percent from 2017 and more than triple the level of 2007, according to an analysis by the Institute of International Finance (IIF), a research and advocacy group for financial firms.

Buybacks now overshadow dividends as the way companies return funds to shareholders. In 2018, dividends from these same S&P 500 firms totaled $449 billion, slightly less than in 2017, says the IIF analysis. The buybacks reduced the number of shares of the S&P companies by 3 percent, the IIF estimates.

The biggest economic sectors using buybacks are information technology companies (example: Microsoft) at $255 billion, financial firms (JPMorgan Chase) at $137 billion and health care firms (Pfizer) at $91 billion. Companies that have announced buybacks include Boeing, Johnson & Johnson and Facebook, reports CNBC, the business news channel.

What encourages buybacks? There are many causes.

One is convenience. When companies raise dividends, they are reluctant to reverse the increases — that’s an almost-certain warning that a firm is in deep trouble — except in cases of extreme financial distress. By contrast, buybacks can be turned on and off to reflect the state of the economy, the stock market and companies’ individual circumstances.

Another attraction is the stock price itself. Many executives “believe their stock is undervalued,” as CNBC puts it. Buybacks try to nudge up the price — not always successfully — by spreading the same profit over fewer shares. President Trump’s large corporate tax cut also spurred buybacks, because some of that money was funneled to shareholders, as Donald Marron of the nonpartisan Tax Policy Center has indicated.

(Note: Some stories put the 2018 buyback total at more than $1 trillion, compared with the IIF’s $753 billion. The difference, says the IIF, is that its figures cover only buybacks that have occurred. The higher numbers also include announcements of buybacks that haven’t been consummated.)

Not surprisingly, there’s a backlash. Sen. Marco Rubio, R-Fla., a staunch critic of buybacks, recently denounced the practice in a series of scathing tweets. Here’s a sampling.

“The justification for corporate buybacks is [a] company has no better investment available. This may be true for any company from time to time. But what does it say when it is true for many companies year after year? … Why are profits not being invested into [the] company or new companies?”

Or here are Senate Minority Leader Charles Schumer, D-N.Y., and Sen. Bernie Sanders, I-Vt., writing on the op-ed page of the New York Times:

“[Buybacks reduce companies’ capacity] to reinvest profits more meaningfully in the company in terms of R&D, equipment, higher wages, paid medical leave, retirement benefits and worker retraining.”

What to believe? By rhetoric, the critics seem winners. Corporate America seems to be hunkering down and enjoying short-term returns at the expense of the future. But this is a superficial reading.

On paper, it seems reasonable to discourage buybacks by imposing stiff taxes on them. However, this turns out to be harder than it seems. For starters, the present tax rate for Americans receiving capital gains from buybacks is the same as the tax rate on qualified dividends, 23.8 percent, notes Steven M. Rosenthal, also of the Tax Policy Center. Buybacks aren’t being wildly subsidized.

Even if they were, the effect of raising the tax on buybacks would be modest, Rosenthal says. Many investors are tax-exempt. These include foreign investors in U.S. stocks, U.S. pension funds, IRAs, 401(k)s, and other tax-exempt institutions. All together they represent about 75 percent of publicly traded U.S. shares, says Rosenthal. All these non-taxable investors would still have reason to favor buybacks.

More important, even banning buybacks outright might not work as critics think. Imagine a world in which buybacks are illegal and companies hoard most of the funds now used for buybacks. (Schumer and Sanders support one such approach.) All that spare cash might encourage executives to undertake wasteful projects or to engineer ever-larger mergers — and be criticized by the same critics for doing so.

Buybacks are the better solution. Funnel some of companies’ surplus profits to shareholders, who can best decide what to do with the cash.

 

(c) 2019, The Washington Post Writers Group