Share buybacks are one of the most interesting conundrums in finance. When are companies justified in using their capital to push up the value of their shares by buying back stock in the open market?
The basis of any investment into a company is to receive a return on investment through dividends, with the expectation that the company will meet its fiduciary duty to maximise its value through profitable growth, leading to an increase in the stock price. This is called ‘shareholder value’.
Successful companies that generate profits build up capital. There are only three things they can do with that capital:
- Maintain it as a ‘cash pile’, invest it carefully and have it ready to spend when market conditions are right for acquisitions or expansion.
- Invest in new factories and productive capacity to improve earnings, productivity, create new and better products, and grow the company profits and market share.
- Return cash to investors if it’s the best option, which may occur when investment returns look uncertain or low and building a cash pile is not necessary.
All these options can meet the goal of maximising the returns to investors – shareholder value. Buybacks, which effectively push up the price of a company’s stock, return cash to investors in a highly efficient way – subject only to capital gain taxes if the holder decides to sell.
For the last 15 years, markets have been fuelled by massive gains in stock prices. However, these returns are out of synch with economic growth: the US economy grew by 40% from 2009-2022, but the stock market rallied 270%, an imbalance created by financial distortion and the price of money being too low, making stocks look excessively attractive. ‘Shareholder value’ became fixated on maximising the price of the stock and buybacks became a key method to push up prices.
Through the 20-teens a vast number of companies borrowed on the financial markets, at ultra-low interest rates, with the intention of leveraging up with debt to buy back their own stock. It was generally accepted as an example of pragmatic markets – there was an arbitrage between the price of money and the price of stock that allowed smart company directors to increase shareholder value by pushing up the stock price with debt. Such moves did little to improve the fundamentals of their businesses and instead increased the overall financialisaton of the economy!
Sometimes a buyback makes good sense. Apple has built an enormous cash pile from the profits of its ubiquitous bright-shiny tech. It maintains a $51bn cash pile (cash and securities) available to seize the moment and make the right acquisition whilst being able to maintain its high stock price through its Stock Buyback programme, which has clearly contributed to making Apple the most valuable company on the planet.
The largest companies tend to be the ones with capital who are in a position to go and buy back their own stock. Many are constrained in what they can buy – with acquisitions often being referred to competition authorities or new investments in non-ESG projects (for oil & gas companies) being blocked by activist investors, meaning its often just easier to go down the buy-back route.
Apple shows it can be done right, but generally stock buybacks should make investors wonder about how good the management of the company is and what their priorities are.
A company with a high level of capital generation from sales or a large cash pile may make a rational decision that the returns to its investors from pushing up its stock price will be greater than investing that cash pile in growth. In the case of Apple, that’s the decision they’ve made – while keeping some powder dry to invest, with the happy effect of also keeping the stock price high via buybacks. It meets any shareholder value test.
However, management that spends too much time thinking about using its capital for buybacks may be too fixated on the financials rather than the business opportunities around them. If they are more interested in creating value by playing the company in the stock markets rather than increasing the company’s fundamentals in terms of market share, new products, raising productivity and building profits, are they really the right management to have in place?
Boeing is a good example of how badly it can go wrong.
In the 20 years since it was famously acquired by McDonnell Douglas using Boeing’s cash, the world’s once best airplane maker, spent $60bn on buying back its own stock. Once it sold aircraft on the basis of its engineering excellence. Now the C-Suite focused on maximising shareholder value, and while doing so feathered their own nests. By negotiating themselves great option schemes and bonuses set relative to the stock price, the management were incentivised to push the stock higher through buybacks.
Boeing’s management not only spent all the profits they had accrued from selling planes, but also borrowed from the bond markets to finance buybacks. To show what great managers they were, they also cut costs to the bone and tuned labour relations within the firm into open warfare – which is a crisis when its engineering quality that matters in the product.
Rather than invest $30bn developing a successor to the venerable B-737 regional jet, the company spent all its capital on buybacks and executive rewards. It decided to stretch the 60-year-old 737 design with bigger more fuel efficient engines and told the airlines it was the same old plane they were already flying.
However, it wasn’t and was fatally unstable, requiring software mash-ups Boeing hid from the airlines and pilots. Whether related or unrelated, two crashes occurred, claiming the lives of 346 passengers and crew members.
Boeing’s stock price collapsed (only saved because it was a critical part of the US military-industrial complex.) After investing $60bn in buying back its own stock it has zero to show for that investment. Today Boeing is unable to afford the cost of developing a new green fuel-efficient air liner. It is now No 2 to Airbus which probably can.
Bill Blain is a market strategist at Shard Capital. The views expressed above should not be taken as investment advice.