Monday, December 31, 2018

Stock Buybacks, Revisited

Stock buybacks are in the news these days.  As a result of President Trump's tax cut program, many companies repatriated billions of dollars in overseas profits and then promptly squandered them by buying back their own stock.  In the last few months of this year, the stock market has tanked, meaning that these companies far overpaid for their own stock, and the money they spent buying the stock essentially went up in smoke - or so they would have you believe, anyway.

As I noted in the very early posting, stock buybacks are one way that a company can pay back shareholders.  The theory is, if you reduce the number of shares, the remaining shares are worth more as they represent a bigger chunk of the company.  Thus, shareholders are paid back by having their stock value go up, which is not a taxable event until they actually sell their stock.  At that point it is only taxable as capital gains, not as income.  And ordinary income is usually taxed in the higher rate than capital gains.

So the people in high tax brackets who own lots of stocks make out on this.  Everyone else sort of doesn't get anything out of it.  And that sort of sticks in the craw of a lot of Democrat Socialists these days.

There are some upsides to stock buybacks other than increasing share price.  And this is a good thing, too, as history has shown that stock buybacks often don't result in a sustained increase in share price. In fact, sometimes they do the opposite.  When a company starts buying back massive quantities of its stock, there is more demand than supply.  As a result, the share price goes up and company buys back their own stock at the highest possible price.

That is the problem with buying and selling huge chunks of stock.  As I noted before, things like market cap are illusory, as they don't represent the real value of a company.  If Bill Gates put all his Microsoft stock on the market tomorrow, the share price would plummet. There would be more supply than demand for the stock. Not only that, people would wonder why Mr. Gates would be unloading stock in his own company, and panic as a result.

So, buying back a big chunk of your own stock - or selling it - will affect the market prices.  Unless you can structure your stock buyback so you buy it back in trickles and drabs over a period of months, or even years, chances are your purchase of stock will actually affect the market price.  And of course, companies have to announce their stock buybacks, which in turn triggers investors to drive up the price of the stock, as they think it'll be worth more as a result of the buyback.

But historically, in many cases, once the buyback is completed, the stock price falls back down to a lower level.  Often the problems with buying back stock cause the stock to plummet.  By purchasing back the stock from investors, the company is not buying back itself but rather paying off its investors with equity. The company no longer has that money on the books - it has less equity - and in theory, the company is worth less money as a result.  So it's no wonder the stock price would plummet after a buyback.  In fact it would be a logical conclusion that it would do so.

The other problem is sometimes companies actually need this money in order to continue operations. In almost every industry today, it is adapt or die.  Whether you are making cars, washing machines, or cell phones, you constantly have to plow money into research and development to come up with the latest and greatest product.  And if your product isn't a hit in the marketplace, you could be bankrupted overnight.

Thus, many analysts criticized stock buybacks as short-sighted.  Companies may need this money later on in order to pay for R&D.  Also, many companies will buy back stock even though they have a lot of outstanding corporate debt - or indeed are taking on more.  This places the company in an awkward position later on if it economic conditions decline - which they appear to be about to do. Debt always has to be paid back, but stockholders don't have to be paid dividends, if things go South.

Buying back stock, in effect, puts more power in the hands of bondholders compared to that of the shareholders.  If a company does go bust, it is the bondholders end up becoming the new shareholders of a company.  Not only that, when a company has more debt than equity, it may be on shaky ground.

But what about the upsides?  If a company continues earning the same amount of money as before, then the earnings per share will increase.  Since your earnings are the same and you have fewer shares, the earnings per share will go up and theoretically this should drive up the stock price.  Of course, what we are seeing in the current economic climate is that earnings are declining. Thus, earnings-per-share are staying about the same - or perhaps maybe dropping - for many companies.

The reasons for this are varied in many, and not just due to the stock buybacks.  We are in an era of record low unemployment - which means wages are ratcheting up.  Due to tariffs and other market conditions, the cost of materials is going up as well.  However inflation is not going up very fast and with rising interest rates people can't afford to pay more for products.  Thus, profit margins are being squeezed.  Maybe stock buybacks are not a bad thing overall, but right now is a really bad time to be buying back your stock.  If we are indeed headed for a recession, having that money on hand would really come in handy.

Similar to earnings per share, dividend ratios might also go up when you buy back your stock.  If you have X dollars a set aside for paying dividends, and you decrease the number of shares, then the dividend per share will go up.  On the other hand, if you pay the same dividend and have fewer shares, the cost of paying dividends will go down, which means you'll have more money from cash flow to use for other purposes.

However, I think the earnings per share and dividend ratio thing really isn't that great an effect.  Since the number of shares is rather large for most companies, the change in these numbers is going to be very slight.  And, as I noted above, if economic conditions changed, earnings per share could remain the same or actually even go down after a stock buyback.

As I noted in my earlier posting on the subject, and as others have pointed out, before 1982, stock buybacks were considered illegal.  It was considered a way of manipulating stock prices and thus in violation of SEC regulations.

Which brings us to the main reason for stock buybacks. When you decrease the number of outstanding shares, in theory you increase the price of the stock.  That is to say, in theory.  But as I've hammered time and time again in this blog, stock prices are based on market perceptions - the law of supply and demand.  They have nothing to do with the actual value of the company divided by the number of shares.  It's the same as with product pricing.  A lot of naive people think that the cost of a car is equal to the cost of its components, labor, and overhead plus a "reasonable profit."  In reality, what you pay for a vehicle is dependent on the supply and demand for that vehicle.  And some are sold at huge profits if they are in high demand - such as SUVs and trucks today - while others are sold even at a loss if nobody wants them.

So you can buy back all the shares you want, it might not budge your stock price at all.  It may cause it to go up or down.  There's not a tracking mechanism linking stock buybacks and share price.  In general, buying back stock does create a short-term boost in share prices, if only because the company is buying back the shares and thus driving up demand and increasing the price of the shares in the marketplace - which used to be called stock manipulation.  If you're an executive with a company and have a stock option that is exercisable, it might be worthwhile to have the company buy back shares so you can exercise your stock option at an all-time high price.

You see how this works - it's called gaming the system.  As an executive for a company, you can increase the share price by increasing productivity, cutting costs, and coming up with new and innovative products that are in high demand.  The company will be more robust and profitable and people will drive up the share price because they perceive your company as successful.

Now, that's a lot of hard work!   A far simpler technique is to dick around with the finances and cause the stock price to go up artificially and then cash out on your stock option and leave the company before they throw you in a Japanese prison like poor Carlos Ghosn.

The last time I wrote about this, I used Ford Motor Company as an example. They started buying back their stock in the 2000s and I was a shareholder and I thought I was happy about this, as I  thought it would make the share price go up.  But shortly thereafter, the share price in fact went down, and in fact the company flirted with bankruptcy in 2008.

Today Ford is struggling against its other American competitors and overseas competition.  Unlike GM and Chrysler, which were able to shed a lot of debt and obligations through structured bankruptcy, Ford decided to hang on.  And one reason they decide to hang on is the Ford family still owns a big chunk of Ford stock.  They would lose control of the company if it went through bankruptcy.

So now the company has a lot of debt and is facing a lot of competition and a slowing market for automobiles.  We are on the cusp of a new era in automotive transportation, it seems. Within the decade we all may be driving electric cars, or in fact electric cars may be driving us.  It remains too soon to tell, but most companies are plowing huge amounts of money into R&D with this goal in mind.

With a recession coming up, and these expensive capital investments needed, Ford is probably wishing it had a little more capital on hand to pay for all this.  All that money spent on stock buybacks could have been more useful on the company's books.

And in the coming months, we may very well see the same effect happen to other American companies.  The money spent buying back stocks could have been used for new product development or indeed just to keep the company afloat during a downturn in the economy.

Of course, companies can always sell back the stock they bought, unless they've decided to retire the shares.  Or they can make new stock offerings, provided they don't piss off the existing shareholders. Or, is it as is increasingly common, they could go to the debt market and issue corporate bonds which seems to be a trendy thing to do these days.  Or, they could look to private-equity to take over the company and take it private - another disturbing trend in recent times.

Personally, I don't view stock BuyBacks as a sign of a healthy and robust economy, but rather as a hollowed-out economy. When too much capital is concentrated into few hands, oftentimes bad things happen.  Usually, these things work out over time, but oftentimes a lot of people get hurt in the process and there was often disruption and sometimes even revolution.

Let's just hope that doesn't happen.