Monday, March 5, 2018

Buybacks

A short oped for the Wall Street Journal here  on stock buybacks. As usual, they ask me not to post the whole thing for 30 days though you can find it ungated if you search. An excerpt:
... Buybacks do not automatically make shareholders wealthier. Suppose Company A has $100 cash and a factory worth $100. It has issued two shares, each worth $100. The company’s shareholders have $200 in wealth.  Imagine the company uses its $100 in cash to buy back one share. Now its shareholders have one share worth $100, and $100 in cash. Their wealth remains the same.
Wouldn’t it be better if the company invested the extra cash? Wasn’t that the point of the tax cut? Perhaps. But maybe this company doesn’t have any ideas worth investing in. Not every company needs to expand at any given moment.
Now suppose Company B has an idea for a profitable new venture that will cost $100 to get going. The most natural move for investors is to invest their $100 in Company B by buying its stock or bonds. With the infusion of cash, Company B can now fund its venture.
 [Left out: The alternative would be for company A to lend the money to company B or to buy its stock. But why are the managers of company A, out of its own ideas, better than its investors at spotting other companies with new projects to invest the stockholders’ money?]
The frequent rise in stock price when companies announce buybacks proves the point. In my example, Company A’s share price stays fixed at $100 when it buys back a share. But suppose before the buyback investors were nervous the company would waste $40 of the $100 cash. Imagine an overpriced merger or excessive executive bonuses. Not every investment is wise! 
The $100, stuck inside Company A, would be valued by the market at $60 and the company’s total value would be $160, or $80 a share. If it spent the $100 to buy back one share, the other share would rise from $80 to $100, the value of its good factory. 
When a company without great ideas repurchases shares, the price of the remaining shares rise. This stock price rise is no gift to shareholders. It is just the market’s recognition that $100 has been saved from inefficient investment.
Full oped in 30 days.

Update: 

Based on follow up commentary, it's pretty clear than 99% of people do not understand the point: It's not about what companies do with today's profits. The case for buybacks is not that cash must chase investment. The point of the tax cut is the profitability of new investment. Without that, somebody will still just sit on the cash. With that, money will find its way to new investment. Otherwise, we're just putting money from the right pocket to the left pocket. Investment in the end comes when it is profitable, looking forward. Nothing about who gets what part of today's profits has anything to do with it. I will stress this next time! A good learning experience.

Tyler Cowen has a good Bloomberg View focusing on this point, my emphasis:
A basic principle of economic reasoning is to think in terms of real resources, not just the first-round flows of money. If a major corporation engages in buybacks, that simply transfers money from one set of hands to another -- from the corporate entity to the shareholders. It doesn’t destroy real resources or determine their final disposition. The money could still go to a venture capital fund, or into private equity or a real estate investment trust, in addition to numerous other undertakings, all of which might boost investment and real wages.

19 comments:

  1. "Economic logic isn't strong in Washington these days, but this effort stands out for its incoherence."

    Dr. Cochrane, it seems to me that dismissiveness and putting on airs is distasteful for scholars to engage in. I wish you and those more liberal economists we shan't name here wouldn't drench all of your commentary in partisan and presumptuous language. It makes it harder to digest your knowledge and experience without picking up a poor impression of your manners. Such language wears poorly on those on the left, I think it wears poorly here too.

    Just my two cents, though. No disrespect intended.

    P.s. I'm going through your investment notes at the moment, good stuff.

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    1. What was partisan about your selected quote?

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  2. If we get a record level of buybacks thew we get a record level of concentrated efficiency. Someone was predicting record buybacks.

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  3. Block if inane.

    I feel like I've been waiting ages for someone to state the bleeding obvious when it comes all the noise about tax cuts and buybacks, so thank you for saving my sanity. That's all.

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    1. The Japanese require wage hikes to qualify for lower tax rates. A buck fifty for small companies and 3 bucks per hour for large companies. That guarantees injection of stimulus into the real economy.

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  4. A boondoggle by any other name is still a boondoggle. Get rid of the corporate tax and overhaul the entire tax system to target real wealth and consumption. Then we don't have to argue over what companies spend their money on anymore.

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  5. "This stock price rise is no gift to shareholders. It is just the market’s recognition that $100 has been saved from inefficient investment."

    I'd always assumed the buyback bump is mostly tax related. A buyback is usually more tax efficient than a dividend, often dramatically so. In theory the stock should go up by at least the difference between the after-tax impact of market's assumed cash return mechanism and the after-tax impact of the declared buyback.

    I say "assumed" because I've never sought to prove this out (who has the time!), so I accept that I very well could be 100% wrong. It just seems intuitive.

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  6. A nice discussion of both theorems from Miller and Modigliani - both of which should be required reading for those who wish to talk about buybacks:

    http://review.chicagobooth.edu/magazine/spring-2015/why-merton-miller-remains-misunderstood

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  7. Another way to look at it is that some companies need capital to fund growth, and others provide capital to fund growth.

    When companies kick out too much cash, there is diminishing returns on those last few dollars of capital. If they get extra capital, of course they're not likely to have good uses of it if they're already very capital efficient.

    But earlier stage growth companies do have need for capital. The need is so acute that they take it from VCs who expect 30-50% annual returns. So every marginal dollar for them helps, but it needs to come from somewhere.

    So IBM and Apple buying back stock is great. The money gets put to higher return use elsewhere.

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  8. Your model assumes stocks are valued at net asset book values. I wonder if that is how stocks are really priced. Would your model make sense if stock prices are based on earnings and unrealized asset appreciation?

    A company has $100 in cash and $100 productive asset. The company earns $10 on its productive asset and the stock is valued at 20 times earnings. The entity value is $200 or $10 x 20. The company has 2 shares outstanding so each would be valued at $100. The company uses its $100 cash to buy back one of the 2 outstanding shares. That leaves 1 share outstanding.
    The company continues to earn $10 with its productive asset so the single outstanding share is now worth $10 x 20 or $200.
    That, as you know, is why companies do share buybacks and that is why

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    1. The cash would be part of the value! The market knows there is excess cash on the books.

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  9. Buybacks have no direct impact on stock prices but it has well an impact on the computation of earnings per share, and that in turn may generate a bias in the valuation of stocks.
    Best regards,

    Etienne

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  10. There are also “market” effects from buybacks that contribute to pushing prices higher, apart from the “fundamental” aspects already mentioned (the “discounted” cash, if valuation is done properly, and the increase in EPS, if “valuation” is done simply by looking at PE multiples):

    When shares of a company are being repurchased, the demand for those shares increases.

    When shares of a company have been repurchased, the supply of those shares have been reduced.

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  11. Prof Cochrane, who do you think are the marginal investors for the Trump tax cuts? I find it hard to believe that it's the large multinationals who comprise the S&P 500. The companies who are doing stock buybacks pre-cut (large public corporations) are also unlikely to invest much more just because the tax on profits falls 10%.

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  12. So the basic conflict of interest is that shareholders expect managers sitting on stockpiles of cash to consume excessive "perquisites"--e.g., taking too many flights on the corporate jet, overspending on their office renovation, investing in "pet projects", etc.--and shareholders will price the firms shares accordingly, so buying back stock effectively reduces managers' ability to "behave badly" in the future (i.e., buybacks are a credible bonding mechanism for managers to commit to behaving themselves). In general, this seems like a good thing, but are there unintended (or perhaps even intended) negative consequences of these buybacks as well?

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  13. "Nothing about who gets what part of today's profits has anything to do with it" - I would argue that buying back stock, rather than giving a special one-time dividend to shareholders, is signaling that management would rather keep its stock price high, by reducing the float and making it more expensive to buy shares, than give money back to shareholders. Surely Prof Cochrane would not argue that stock buybacks have no effect on the price of the stock? And by keeping the stock price high, management keeps their bonus options 'in the money' and their bonuses intact.

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  14. I agree that buybacks save the cash from a bad investment, but there is also the half-empty glass version of this story: imagine you're a company CEO with an EPS target to make your yearly bonus. Do you invest in a project with an uncertain payoff or do you buy back shares to boost EPS? It's a no brainer to me.

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  15. Investors buying the stock of a company, doesn't "inject capital" into that company unless it issues new shares.

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  16. "Nothing about who gets what part of today's profits has anything to do with it." << this is almost always wrong.
    For top management decision makers, the agency problem often dominates, but is always an influence. If bonuses/options/benefits are based on "higher share prices", there will be an agency bias towards safer buybacks to increase the price.

    If not, there should be dividends, acquisitions, reduced debt, increased R&D, or increased wages -- all of which are valid alternative uses of buyback cash, with their own sets of advantages & problems.

    Maximizing the marginal increase in company value from the mix of these alternatives is part of the strategic "entrepreneurial premium" each firm is paying it's top execs for deciding on; the mix includes top exec bonus formulas.

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