Stock Buybacks: Concerns over Debt-Financing and Long-Term Investing

Stock Buybacks: Concerns over Debt-Financing and Long-Term Investing

December 19, 2019
Stock Buybacks: Concerns over Debt-Financing and Long-Term
Investing
A stock buyback occurs when a publicly traded firm
but not the other. A buyback and a dividend are similar in
repurchases some of its shares from investors with excess
the sense that they both involve redistributing cash to
cash or borrowed funds. In recent years, the annual
shareholders. In contrast to buybacks, dividends have a
aggregate value of such repurchases has risen to historical
much longer history and tend to represent an ongoing
highs, reaching nearly $1 trillion as firms such as Apple,
commitment to shareholders that firms are reluctant to stop
Exxon Mobil, Microsoft, IBM, Visa, Citigroup, Cisco,
for fear of sending a negative signal to securities markets.
Pfizer, Oracle, and Bank of America have conducted
There is generally no expectation that firms will continually
billion-dollar-plus stock repurchases. As aggregate buyback
conduct buybacks.
levels have soared, general scrutiny of them has intensified.
In the past, dividend payments were larger than buybacks.
Legislation related to buybacks has also been introduced in
But, over the past decade or so, the aggregate annual size of
Congress. S. 915 and H.R. 3355 would prohibit a firm from
stock buybacks began to eclipse that of dividends and now
conducting a buyback. S. 2391 would ban buybacks unless
greatly exceeds it. Scrutiny of buybacks also appears to
they were accompanied by new buyback disclosure
have been heightened after the enactment of the 2017 tax
reforms. S. 2514 and H.R. 4419 would levy a tax on
revision (P.L. 115-97), sweeping tax legislation that
companies that did not distribute a worker “dividend” from
resulted in overall corporate tax cuts. Historically robust
their profits. The dividend’s size could be based on the size
dividend payments ensued, but the significant increases in
of the company’s recent stock buyback. As part of broad
buybacks got more media attention.
private equity fund reform, S. 2155 and H.R. 3848 would
prohibit buybacks by firms in which a private equity fund
Firms in the widely followed S&P 500 stock index account
has acquired a controlling interest.
for about 80% of overall domestic stock market
capitalization and are also responsible for the vast majority
Central concerns over buybacks are that they (1) represent a
of stock buybacks. In 2018, the firms in the index reached
problematic short-term-oriented use of firm assets at the
$800 billion in aggregate stock repurchases, a historical
expense of longer-term investments; (2) are often exploited
high. The Federal Reserve’s Flow of Funds data on
by senior executives for personal financial gain; and (3) are
aggregate corporate net equity issuance (newly issued stock
often debt-financed, which can increase firm vulnerability.
minus repurchased stock) is widely viewed as providing the
most meaningful information on buyback trends. (Negative
Others, however, emphasize that buybacks (1) can help
net issuance means that stock repurchases exceed stock
signal that a company’s stock is undervalued; (2) are often
issuances.) The data indicate that negative net equity
used to offset share dilution due to the issuance of new
issuance was at a historical high for nonfinancial firms
stock to accommodate stock- and stock option-based
between 2016 and 2018 (with the exception of the eve of
employee compensation programs; (3) represent the most
the financial crisis in 2007), in the $500 billion range.
financially prudent use of the cash used to finance them; (4)
boost capital formation through shareholder reinvested cash
Perceived Undervaluation and Buybacks
proceeds; and (5) have greatly buoyed the current bull
The predominantly cited rationale for why firms conduct
market, which is a hotly debated assertion.
buybacks is that senior officials perceive that their
company’s stock is undervalued. Removing repurchased
Background
shares (absent newly issued stock) from the market
A firm’s net income (also called net profit) is the remaining
diminishes the supply. Assuming that demand stays
cash after operating expenses, interest, and taxes are
constant, in theory, the share price should rise.
deducted from its revenue. It is also the funding source for
Complicating this dynamic, however, are instances when
voluntary quarterly distributions to shareholders, known as
the securities market discounts a stock’s price due to the
dividend payments. A firm may also use its net income to
removal of a valuable firm asset: the cash used to
buy back or repurchase its shares on the open market (the
repurchase the stock.
secondary stock market where shares are traded). Stock
reacquired via a buyback is called treasury stock and is
The mere announcement of a buyback program, a large
either permanently removed from stock-market circulation
fraction of which are not implemented, is widely observed
or retained by a company to be resold in the future.
to often result in a short-term share price boost.
Historically, however, firms have generally been inefficient
Some publicly traded firms may not pay dividends or
at timing their buybacks when their share prices are
conduct buybacks. Some may conduct a buyback and pay
advantageously low (for them, but not for their
dividends during the same period, while others may do one
shareholders, who would prefer a buyout at higher prices).
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Stock Buybacks: Concerns over Debt-Financing and Long-Term Investing
Regulation 10b-18
Related research from Lazonick et al, found that between
Adopted in 1982 by the Securities and Exchange
2006 and 2015, 18 leading pharmaceutical companies on
Commission (SEC), which regulates equity market trading,
the S&P 500 stock index spent 11% more on buybacks and
Rule 10b-18 gave companies a legal safe harbor when
dividends than on R&D. As a result, the study concluded
undertaking a stock buyback program by ensuring that
that innovative existing drugs tend to be too costly and
firms that repurchase stock are not generally subject to legal
badly needed innovative drugs tend not to be produced.
liability for manipulation under the Securities and
Exchange Act of 1934 (P.L. 73-291) when the volume of
Research by Gutierrez and Philippon in 2016 found that
daily stock buybacks does not exceed 25% of the previous
economic analysis indicated an overall investment gap
four weeks’ average daily trading volume in company
across individual domestic firms. They partly attributed that
stock.
underinvestment to firms opting for buybacks over
investments. That same year, work by Lee, Shin, and Stultz
By various accounts, in the years after Rule 10b-18 went
examined individual firms in industries in which economic
into effect, there has been significant growth in buybacks,
analysis indicated that their market value exceeded the
annually dominated by a few large capitalized firms.
value of their combined assets, suggesting that they should
According to Reuters, 60% of the approximately 4,000
be investing more. The authors, however, found that the
publicly traded nonfinancial U.S. companies conducted
firms tended toward expanded buybacks, but weak
buybacks between 2010 and 2014.
spending on investments.
Leveraged Buybacks
By contrast, some academics and members of the business
Fostered in part by low interest rates, a large number of
community stress that buybacks represent a rational
buybacks have been funded by debt and are known as
response to a firm’s assessment that it lacks fiscally prudent
leveraged buybacks. Data on the percentage of buybacks
new investment options. For example, New York
that are leveraged are inconsistent. For example, the bank
University financial economist Aswath Damodaran has
J.P. Morgan Chase reported that leveraged buybacks
observed that many firms with the largest buybacks are in
accounted for 14% of overall buybacks during 2018, which
the late stages of their lifecycles and may have a diminished
it said was the lowest percentage since 2009. But Yardeni
need for significant R&D and/or CAPEX.
Research, a respected securities market research firm,
reported that they were 56% of the total.
In a 2018 article in the Harvard Business Review, Wang
and Fried observed that buybacks and dividends among
Whereas prudently managed corporate debt levels can be
S&P 500 firms between 2007 and 2016 were 96% of their
financially beneficial to firms, excessive levels can place
excess cash (often used interchangeably with net income).
them in financial jeopardy. And if corporate debt levels are
But the two wrote that this is misleading because the firms’
systemically excessive, the overall economy may become
net shareholder equity payouts—combined company
destabilized. A 2019 article from Federal Reserve staff
distributed and repurchased equity from dividends and
observed that aggregate nonfinancial corporate debt has
buybacks—were a far less burdensome 50% of excess cash.
been rising as a share of the aggregate book value of firms’
Wang and Fried also examined CAPEX and R&D as a
assets, which it said represented a potentially troubling
percentage of revenue (a commonly used metric of
macroeconomic development. The principal uses of that
corporate investment intensity) for S&P 500 firms over the
increased debt, it noted, have been corporate acquisitions,
past quarter of a century. They found that, although it was
stock repurchases, and dividend payments. However, it
highly volatile on a year-to-year basis, it has been rising
concluded that risks from the added debt were “mitigated in
over the past decade, and is close to its peak levels during
part by higher corporate cash flows.”
the late 1990s.
Buybacks, Research and Development,
A 2017 Federal Reserve staff study found that aggregate
and Long-Term Physical Capital Assets
firm data both in and outside of the United States appeared
For many firms, adequate expenditures on research and
to provide limited evidence that large shortfalls in overall
development (R&D) and long-term physical capital assets
corporate investments have been associated with large
(CAPEX) are essential for long-term sustainability and
increases in share buybacks and/or dividends. However, it
growth. Various observers, including Members of
also indicated that this was far from conclusive and that
Congress, individuals in the financial services industry, and
more research was needed, particularly at the firm level.
some academics, have argued that funding buybacks (and
sometimes dividends) problematically displaces spending
Related CRS Products
on R&D and CAPEX.
CRS Legal Sidebar LSB10266, Stock Buybacks:
Background and Reform Proposals, by Jay B. Sykes.
Some critiques of buybacks, including a February 2019
New York Times editorial by Senators Chuck Schumer and
Gary Shorter, Specialist in Financial Economics
Bernie Sanders, reference 2014 research that showed S&P
500 stock index firms who conducted buybacks and/or paid
IF11393
dividends tended toward using more than 90% of net
income to fund them, leaving little room for R&D and
CAPEX.
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Stock Buybacks: Concerns over Debt-Financing and Long-Term Investing

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