I have always been skeptical of stock buybacks, but I have viewed them as almost a necessary evil, in terms of them being inevitable when looking for companies that actually return cash to shareholders. Then, with Microsoft announcing a $40 billion stock buyback when its stock price was near an all-time high, and now Gilead announcing that it is largely stopping its buyback after its price dropped by 1/3rd (despite tremendous cash flow), I decided to look more into the benefits, if any, of stock buybacks.

Let’s start with some legitimate reasons for stock buybacks. They are tax efficient, in that there is no consequence to me as a remaining shareholder for the company to reduce the number of shares outstanding and therefore increase the value of each remaining share. Stock buybacks also reduce the cost of dividends, as there are fewer shares to pay dividends upon. Stock buybacks have more flexibility, as they can be started, stopped and used whenever desired by the company without the same effect on the stock price as a dividend cut. Finally, they can serve as a signal to investors that the stock is undervalued.

Then there are legitimate reasons that stock buybacks are less than beneficial. They help executives meet earnings per share and other per-share targets, which may earn them bonuses, and they increase the value of their stock holdings, at least temporarily, all without necessarily improving shareholder returns in the long-run. As a result, management could be attempting to send the signal to investors that the shares are undervalued when really management just wants to pad their own wallets.

Also, there is little proof that buybacks are beneficial to shareholders in the long run:

Courtesy to CNBC for the chart.

Based on a few articles that I read, it appears that stock buybacks may cause an initial bump in the stock price, but that in the long run it hurts the stock’s performance. One exception may be companies that infrequently announce stock buybacks, then announce one and actually follow through with purchasing the shares. How many companies actually repurchase their own shares only when they are cheap, much less also sell their shares when they are expensive?

Perhaps more important than the idea that buybacks enrich executives at the expense of shareholders is the theory that buybacks have, in the aggregate over the years, actually harmed society. This is because the hundreds of billions of dollars that have been wasted on stock buybacks could have, at least in part, been used to build plants and equipment (or stop plants from being shut down), perform more research and development, retool, educate and compensate employees, etc. One could argue that our middle class might be in much better shape today had companies stopped shipping jobs overseas, shutting down plants in the U.S. and laying off every employee possible in an effort to squeeze an extra few dollars of cash flow that was ultimately wasted on share repurchases that helped executives, and instead used some of that money to prepare their equipment and employees for the future, enter new markets, and make more money in the long-haul.

Management is too short sighted in almost all ventures, and this is reflected in executive compensation models often forced down companies’ throats by hedge funds, which usually maintain their position for a year or two at most before selling. Management should certainly have skin in the game in terms of share ownership, but by no means should the stock’s price or any other per-share metric be a significant determinant of executive compensation. Rather, management should be compensated based upon long-term objectives that enrich the whole company (employees, shareholders and the community).

Here are some examples of appropriate management compensation models:

  1. Compensation based on a rolling five year average of return on invested capital and/or return on cash flow, so that if management wastes the company’s money on low-yielding projects (a common tendency) then management shares in the loss.
  2. Compensation tied to other long-term, job specific, objective measures that benefit the company as a whole, such as improved employee retention (which improves job performance and reduces litigation among other things).
  3. Bonuses should be paid over time and subject to forfeiture, whether due to termination or poor management in future years. If management is consistently successful, then they should be well rewarded, but we are all sick of seeing CEOs make hundreds of millions of dollars while their company is barely treading water.

One key with executive compensation is to prevent stock buybacks as a means of enriching management at the expense of other shareholders. There are also many other ways to incentivize employees other than with money, and those methods should be implemented as well based on how each employee is best encouraged to help the company succeed.

Back in 2014, I read through all of Warren Buffett’s annual shareholder letters with Berkshire Hathaway (I’ve read all the subsequent ones too). Taken together, I think Buffett presents a master’s class in corporate governance. Regarding buybacks and efficient use of cash flow, Buffett stated that the higher the return on equity (ROE) of a company, then the more content you should be with the company retaining its cash flow, but if it is lower, then you should demand dividends and possibly buybacks. Buffett also stated that if buybacks occur when prices are too high, then that should scare you away from the stock. Regarding management compensation, Buffett stated that he bonuses management based on their performance in what they can control, without regard to age, seniority or stock price, with return on equity and return on invested capital being two of his preferred metrics.

Here is a quote from Warren Buffett in the 1989 Berkshire Hathaway shareholder letter:

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call “the institutional imperative.” In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.

We should be looking for companies fighting against the institutional imperative. If a company has recently been extremely successful, and especially if it is still operated by its founder who had the vision and skill to navigate the company to success, then those are signs that leadership is having success in this effort. When a company states that it compensates its employees based on how its peers compensate their employees, then that is a great example of following the institutional imperative.

Well, this started out as a complaint against stock buybacks, evolved into a brief discussion of management compensation and ended, as most things should, with what Warren Buffett has to say on the topic. I definitely want to spend more time looking for companies that exhibit good decision making in terms of the use of cash flow and have appropriate management incentives in place.

-Richard

Disclaimer