Why Management Loves Share Buybacks
During the past three years, members of the Standard & Poor's 500 Index have spent more than $1.5 trillion buying back stock. This has led to a reduction in their shares outstanding of at least 4 percent in just the past year alone, by some measures.
Or has it?
A recent research report published by Research Affiliates (RAFI) cast doubt on that share reduction count.
According to RAFI's study, U.S. companies issued stock equal to $1.2 trillion last year. All told the new issues in 2014 exceeded share buybacks.
The RAFI study also found that "the cash flow statement often fails to report the majority of a company’s stock issuance.” Much of that unreported issuance is used as compensation for employees, primarily management. “When management redeems stock options, new shares are issued to them, diluting other shareholders” the report further notes. “A buyback is then announced that roughly matches the size of the option redemption. This facilitates management’s resale of the new stock."
The conclusion is that what looks like buybacks are actually thinly veiled management-compensation plans, or in RAFI's words, “simply a mirage.”
Looking back over the period from 1935 to 2014, the historical dilution rate for equities is 1.7 percent, which is in line with last year’s dilution rate of 1.8 percent. Despite the talk about surging buybacks, the net changes have been only slightly more dilutive than average.
The poorly disclosed compensation structure is only half of the problem with buybacks. Timing and pricing are another big issue.
Consider Caterpillar. The Wall Street Journal’s Justine Lahart noted that the company had spent $8.3 billion to buy back 91 million shares at an average price of $90.71. The shares now trade at about $72, more than $1.5 billion less than Caterpillar paid for those shares.
Wal-Mart, which is perpetually buying back its shares, provides a textbook example of why a company shouldn't do repurchases until it has checked off everything else on a to-do list for cash uses. For years, the company let the condition of its stores slide as we discussed earlier this year. Eventually, customers noticed, which forced Wal-Mart to start cleaning things up -- but only after its stock took a beating on disappointing earnings and a pessimistic profit forecast. It makes you wonder why the billions it spends every year on buybacks wasn't used earlier to keep its stores in shape.
When it comes to using stock buybacks for management to compensate itself, the crown might belong to Dell. From 1998 to 2006, according to the New York Times’ Floyd Norris, “Dell reported net income of $17.9 billion — and it spent $24.1 billion buying back stock.” The longer the time period you look at the worse it gets. From 1997 to 2012, Dell purchased $39 billion in shares -- more than the company has reported in net income over the entire course of its existence.
No wonder it went private.
The timing of Dell’s buybacks was consistently terrible, but since the costs were paid by shareholders and the proceeds went to management, the C suite never seemed to care much. Harvard Business Review looked at the phenomena and called it “Profits Without Prosperity.”
The runner up to Dell might be Qualcomm. As the Times’ Gretchen Morgenson noted this summer, during the past five fiscal years, Qualcomm repurchased 238 million shares at a cost of $13.6 billion.
Despite that huge buyback program, the Times wrote, “Qualcomm’s average diluted share count has actually increased over the period by almost 41 million shares. That’s a 2 percent rise since 2010...because the company has been granting a treasure trove of stock and option awards to its executives.”
Qualcomm paid an average of $56.14 a share for stock that now trades for about $4 less. In other words, it overpaid by almost $1 billion.
This is a pattern we see over and over. Here's another pattern: Although many companies seem to buy shares just before they start falling, managers tend to do much better at the timing game, selling their own shares right before the slide begins. Just a coincidence, I suppose.
Given a choice between dividends or buybacks, I'll take the quarterly check. But the bigger question is simply this: Why is management at so many companies bereft of better ideas and more productive uses for corporate cash?
Maybe it's because so much of the proceeds of buybacks end up in their own pockets.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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