Stock buybacks — when companies purchase large portions of their outstanding shares on the open market, driving up their price — are having a heyday. April 2015 was the biggest month for stock buybacks in U.S. history, and one research firm is predicting that buybacks could set a new record this year by topping $1 trillion.
What could possibly be wrong with such free money (you might ask)? Well, it’s complicated — but we think we can explain in one concise article why stock buybacks and other common maneuvers can create a too-rosy picture of a company’s financial health and how we at Clean Yield try to cut through all the hype.
For many years, managements seemed to balance their responsibilities to their shareholders with those to employees and the communities where they operated, so many investors (ourselves included) considered it a good thing when a company used excess cash to purchase its stock in the stock market. It was certainly a preferable alternative to expensive mergers whose touted “synergies” didn’t always materialize as promised. Defenders of buybacks also like to point out that they re-route cash to investors, who can often reinvest it in the broader economy in a more productive fashion than the company can reinvest it in itself.
But in recent years, executive compensation has shifted from an emphasis on base salaries to incentive-based compensation linked to share price. This shift was originally welcomed by shareholders as a measure ensuring that senior executives had skin in the game; it also responded to backlash against excessive base salaries for executives. But these good intentions backfired when many executives learned to game the new system by pursuing stock buybacks to inflate their own paychecks. This has distorted — even perverted — strategic decision making.
When excess cash is used to buy up company stock in the open market, the number of shares outstanding in the market is reduced, and this tends to drive up the share price — all other things being equal — in two ways. First, the company’s profit is spread over a smaller number of shares, which makes earnings per share higher — and the price of a share of stock higher in return. Second, the supply of outstanding stock shrinks, relative to the demand in the market, causing the price per share to rise.
When announcing share repurchases, managements typically claim that they don’t have attractive reinvestment opportunities for excess cash. But share buybacks tilt the balance toward managements and shareholders at the expense of other stakeholders in a company, notably its employees and the communities the company operates in. “Stock buybacks should be illegal. They are manipulation of the market,” University of Massachusetts professor and buybacks expert Steven Lazonick told The Boston Globe. Other political and business leaders are speaking out against them as well, including Securities and Exchange Commissioner Kara Stein, BlackRock Chairman Laurence Fink, and Democratic presidential candidates Hillary Clinton and Bernie Sanders. As Massachusetts Senator Elizabeth Warren has emphasized, until a 1982 SEC rule change that opened the way forward for them, stock buybacks were treated as market manipulation.
|Since 2004, companies have spent nearly $7 trillion purchasing their own stock — equivalent to about 54% of all profits from S&P 500 companies between 2003 and 2012, according to buybacks expert Steven Lazonick. Last year, the S&P 500 corporations spent all but 2 percent of their profits (or $904 billion) on buybacks and dividends; buybacks accounted for $553 billion of that total.April 2015 was the biggest month for stock buybacks in U.S. history, and one research firm is predicting that buyouts could set a new record this year by topping $1 trillion.|
In August, responding to a query from Wisconsin Senator Tammy Baldwin, the SEC admitted it has no ability to enforce the main rule intended to prevent market manipulation when companies buy back their own stock, and has no intention to do so.
It is difficult for anyone, especially for a regulator, to determine when a company does or does not have better uses for cash than to repurchase its shares. Higher dividends to shareholders seem preferable, but unlike a one-time stock buyback to address (temporarily) large cash balances, dividends are ongoing payments — and managements understandably are reluctant to cut regular dividends once they’ve been increased. In fact, many leading companies tout their records of consecutive years with dividend increases. A one-time “special” dividend would be a way to avoid having to sharply increase a regular dividend and later reduce it when cash conditions change. We instead would favor measures to curb executive pay, which has soared over the past two decades as pay for the average worker has stagnated at best.
Beat the Estimates
The quarterly ritual of earnings announcements is also often fraught with another form of financial engineering that ends up benefitting corporate managers and Wall Street analysts over shareholders or the broader economy. In this game, managers lowball their public profit estimates and Wall Street analysts play along by publicly making profit estimates that are unrealistically low. When actual profit results are announced and they are better than analysts had publicly estimated — quelle surprise! — the stock rises due to the “good news.” Managers with enormous stock options and restricted stock get richer, and the analysts look good by recommending stocks that go up. Everyone wins, right?
Not necessarily. Playing the “beat the estimates game” diminishes financial integrity and trust in the system. Alarmingly, a recent survey of nearly 400 chief financial officers revealed that they believe that 20% of public firms intentionally misrepresent their earnings.
The magnitude of such misrepresentation is large — of firms that do it, an average of 10% of the reported earnings is misrepresented. In addition, the misrepresentation goes both ways with a full one-third of perpetrators lowballing their reported earnings.
The most popular reasons for earnings misrepresentation are desire to influence stock price, related internal and external pressures to hit targets, and executive compensation and career concerns. The main consequences of poor earnings quality are stock price declines and increased cost of capital; effects on analyst following and bid-ask spreads are small, at least for large, established companies.
We try not to let our (long-term) view of a company be influenced by this tactic in short-term earnings reporting. Our primary emphasis is on a stock’s valuation based on the cash the business generates, along with the financial condition and quality of a company’s management and the usefulness of its products and its consideration of workers, communities, and the environment. We’ll leave it to others to jump on a stock or bail out based on whether they “beat” the consensus earnings and revenue estimates or “missed” them.
We’ll Just (Not) Expense It
A third type of collusion between corporations and Wall Street analysts concerns the financial reporting of quarterly earnings. Some companies effectively present their profits in two ways. One method is required, the other (more favorable) is highlighted to analysts and investors. This is particularly common among technology companies, which issue large amounts of stock as compensation to top executives, while not claiming them as cash expenses so they don’t have to be deducted as an expense in calculating net profit. (Of course, if the companies didn’t issue lots of stock, they would have to pay much more in cash salaries and bonuses, which clearly are expenses.) In this way, management gives a misleadingly positive and possibly unsustainable picture of the company’s financial health. Some companies also exclude the expense of writing down the cost of poor decisions, particularly prior expensive — and unsuccessful — corporate mergers. This, too, understates expenses and overstates earnings.
Making Sense of it All
Share buybacks, the estimates game, and understating expenses often seem to fall into the category of “financial engineering” to manipulate share prices for the benefit of corporate management. Due to this, we include “financial integrity” among the ethical characteristics we’re looking for in companies that produce useful, high-quality goods and services. This means paying reasonable compensation to management and reporting accurate, transparent financial results. We assess companies with experienced skepticism and financial conservatism, and we include a significant margin of safety in our projections. For Clean Yield, the highest (reported) profit isn’t always best.
“Companies Pour Billions Into Buying Back Stock But Workers and Economy May Be Paying High Price,” Boston Globe, May 30, 2015.
“Stock Buybacks Draw Scrutiny From Politicians,” New York Times, August 11, 2015.
“S&P 500 May Hit Another Record for Buybacks This Year,” Wall Street Journal, August 18, 2015 .
“SEC Admits It’s Not Monitoring Stock Buybacks to Prevent Market Manipulation,” The Intercept, August 13, 2015.
“CFO Survey: 20% of Companies Distort Earnings Within GAAP,” The Corporate Counsel blog, August 18, 2015.
Tags: Earnings estimates, Financial integrity, Securities and Exchange Commission, Stock buybacks