Put the Brakes on Share Repurchases
If you are the CEO of public company a sizable portion of your compensation is based on a single decision: how much of your company’s stock should be repurchased. The financial press is awash in articles describing the debate between Carl Icahn and Apple about the amount of stock that Apple ought to repurchase. I don’t have a view on this particular battle, but it got me thinking about buybacks and led me to William Lazonick’s article in the Harvard Business Review. “Profits Without Prosperity” is a scathing attack on the practice. According to Professor Lazonick, between 2003 and 2012, S&P 500 companies devoted 54% ($2.4 trillion) of their profits to open market stock repurchases. Another 37% went to dividends, which means that only 9% was plowed back into businesses. In other words, large public companies invested most of their profits in investors rather than their businesses.
Why is this practice so prevalent? Professor Lazonick argues that executive compensation is part of the reason:
In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.
In other words, CEOs and their colleagues have a great deal of short-term incentive to try to control short-term stock prices (in a recent column for the News & Observer, I discussed the role of earnings surprise as a factor in driving short-term volatility). If a company’s stock were truly undervalued, a share repurchase would make good sense. However, academic studies show that buyback programs aren’t tied to a company’s valuation and actually decrease during bear markets.
Rather, share repurchases are a legal form of stock manipulation. SEC rules allow companies to buy up to 25% of stock’s average volume without providing any notice. In other words, when you purchase or sell a stock you may be in the market alongside the company, which has a systematic information advantage. It hardly seems fair and is worthy of attention given the prevalence of the practice. Perhaps if CEOs spent less time repurchasing shares, they’d focus a bit more on reinvesting in the business. And if they don’t have any good uses for the company’s profits they should either pay it out as a dividend or resign.
There’s a certain regulatory asymmetry at work. If a company wishes to sell stock to the public, it has to make a specific filing and give notice of the sale. If a company wishes to repurchase stock, it only needs to issue a broad statement of intent. I’m sure you’ve seen these notices, which seem to excite traders. The announcement goes something like this:
Company A intends to purchase up to x million shares between now and December 31, 2015. Company A may or may not make such purchases and may terminate the program at any time.
That’s really all there is to it. If the company has complete discretion over the plan, it will be subject to blackout periods if there’s a pending announcement of material information. However, if it adopts a non-discretionary plan (Rule 10b5-1), there are no blackout periods. A company can even use a bit of both techniques to shrink the number of shares and thereby boost earnings per share.
I don’t think there’s any reason for companies to incur the equivalent expenses of an IPO or secondary stock issuance when they repurchase shares. However, I believe investors ought to know when a company is buying shares, just as they know when it is selling them. This way those selling the stock will be fully aware that the company itself is a purchaser. In short, I agree with Professor Lazonick that companies ought to have to make a formal tender offer for shares. It might not be good for executives or hedge fund managers, but it would be good for long-term investors, if there are any left.