Why CEOs should be rewarded for stock buybacks

By Felix Salmon
May 6, 2013
Scott Thurm and Serena Ng have an odd piece in today's WSJ, complaining about executive pay being tied to per-share results rather than overall numbers.

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Scott Thurm and Serena Ng have an odd piece in today’s WSJ, complaining about executive pay being tied to per-share results rather than overall numbers. Their poster child is Safeway CEO Steven Burd, who has overseen a substantial increase in earnings per share even as sales and profits have gone nowhere, by spending $1.2 billion on stock buybacks.

The implication here is that public companies should be concentrating on growth, rather than on more financial metrics like earnings per share or return on equity. And I think that’s exactly wrong. Not all companies should be growing; some of them, in order to maximize their return on capital, should instead be shrinking. The world’s biggest banks are a good example: most of them are trying to shrink, because doing so will make them leaner, more efficient, and ultimately more valuable.

Stock buybacks aren’t always a good idea: companies do have a tendency to spend far too much money on them at exactly the wrong time, when the share price is high. (There are many examples, but one of the most tragic is probably the New York Times Company, which today is in desperate need of the $2.7 billion it spent on stock buybacks between 1998 and 2004, when the stock was much more expensive than it is now.)

On the other hand, stock buybacks are a very efficient way of returning money to shareholders: they’re basically a pick-your-own-dividend scheme. Many shareholders, especially individual shareholders in high tax brackets, dislike dividends, because they’re taxable income. But if a company takes the money it would otherwise spend on dividends, and spends it instead on buybacks, then shareholders have a choice: they can sell any proportion of their shares back to the company, in line with their liquidity needs, and if they sell nothing then the value of their shares goes up just because the total number of shares is going down. On top of that, companies don’t feel the same need to maintain a steady level of buybacks, in the way that they do feel the need to maintain a steady level of dividends.

If more public companies concentrated on earnings per share rather than overall earnings growth, that would probably be a good thing. Right now, it’s almost impossible to be a successful CEO of a public company whose industry or company is in long-term secular decline. And private-equity companies are well aware of that fact: they love to buy up such firms and extract vast amounts of money from them before they die. Rather than see the spoils of such tactics accrue mainly to the Mitt Romneys of this world, it would be great if the broad shareholding public could also participate in the efficient rotation of capital out of declining industries and into growing ones.

That’s the way the stock market is meant to work, after all: you invest in companies while they are growing, in the hope and expectation that you will be able to make money from their high future cashflows once they reach maturity. But in practice the stock market has great difficulty valuing companies which make large but falling profits, with the result that most of those profits ultimately end up going to private-equity types once the companies are acquired in a leveraged buy-out.

Safeway is faced with a choice right now: it can burn billions of dollars in what would probably be a fruitless attempt to compete with Walmart, or it can return those billions to shareholders, to be reinvested in more promising areas. Safeway’s CEO should choose between those options dispassionately, rather than simply assuming that more investment is always better — and his board should compensate him in such a way that he’s incentivized to make the best decision, rather than always going for growth.

Stock buybacks are an efficient way of returning money to shareholders of a shrinking company, and as such they’re an important part of the public-company CEO toolbox. I’m sure they can be abused at times to manipulate quarterly earnings. But they can also be a pretty efficient way of doing what the stock market is meant to do best: distributing capital to where it can be most effectively deployed. If Safeway has more capital than it can efficiently use, then it should return that capital to the market, where it can be recycled into more promising investments. And in principle it’s entirely reasonable to reward the CEO for doing just that.

Comments
11 comments so far

Felix, shareholders don’t need companies ot buy shares back in order for them to sell their shares. There’s this thing called the “stock exchanges”, where anybody who owns shares can sell them to anybody who wants to buy them. Nobody needs the company to buy shares back in order to sell them.

And “they’re basically a pick-your-own-dividend scheme”. You know that’s not true, selling your shares (which, I remind you, you can do at any time) is not the same as getting a dividend, and once you sell it, you don’t get any more dividends.

Your faith in stock buybacks assumes that share prices always track earnings per share, when they do not. P/E ratios vary all the time, which means that an increase in EPS may not necessarily boost share price. If that was the case, then Apple wouldn’t have been in the position to react to their declining share price, because it would have stayed above $700, as their EPS were not declining.

You keep saying that share buybacks are “returning money to shareholders”, but I have not received a cent from Apple for any of the shares that I own because of the buybacks. I’ll get dividends from them, but nothing from them buying shares. If anything, they should have split the stock; a lower share price will have a bigger psychological impact on the price than a buyback. The buyback will temporarily drive share price up as they increase demand for shares, but once they are done buying, the price will return to a level that speculators think is appropriate, whatever that is (and apparently will have nothing to do with the EPS).

Posted by KenG_CA | Report as abusive

Ken, you should take your argument to its logical conclusion. If markets are fully divorced from fundamentals (like, um, how many shares are outstanding), the CEO should issue more shares. You can dilute current shareholders without actually dropping the share price, and have more cash on hand!

Posted by absinthe | Report as abusive

absinthe, I don’t think Apple needs more cash. :-)

Often, when companies have secondary offerings, their stock price jumps, because, well, who knows, I guess people think it’s a good sign.

I wouldn’t say the markets are fully divorced from fundamentals, either, only that they are not tightly coupled. The idea that share buybacks will lead to higher share prices only works when the share price has been, and can maintain, a constant P/E. I just don’t see that happening all or even most of the time.

Posted by KenG_CA | Report as abusive

I agree 1000% with KenG_CA. Buybacks return cash to SOME shareholders.

Dividends are an ongoing commitment… a responsibility. Lets say my stock is cheap and so I announce a billion dollar buyback… I lower the share count increase EPS…best case scenario. What happens when my billion dollar buyback is complete…

…assuming my company is still generating cash I can go out and make a wildly overpriced acquisition… or just hoard cash on the balance sheet like some kind of look mine-is-bigger-than-yours trophy.

…but if I declare a dividend… well then I need to continue to meet that commitment on a going forward basis. That forces me to be very judicious with every dollar I make.

The only time I would favor buybacks over dividends are those rare cases when the stock price is below book value. If you can buy back stock below book value you actually raise book value per share!

Posted by y2kurtus | Report as abusive

KenG_CA misses the point. Most of Apple’s cash is outside of the USA where it remains untaxed. Borrowing to buy back shares makes sense only because of how the US Tax Code distorts markets, but make sense it does.

That said, far too many companies buy back shares without regard to their share price. Buybacks make the most sense when the stock trades below book value, or intrinsic value – if you know who that might best be calculated.

Pre-crash AIG was engaged in a stock buyback program even though the stock was at historic highs and the company needed cash to cover unhedged bets. I do not follow Safeway in particular, but the grocery business in general is a business where the established chains don’t have a competitive advantage.

What Safeway is doing may well make sense, but should CEOs be massively rewarded for doing the least risky thing? I don’t think so.

Posted by OregonJon | Report as abusive

Felix..disappointed with you…You usually know better. Academic studies suggest that share buyback are usually better for executives than shareholders

Posted by MyWebName | Report as abusive

OregonJohn, I’m not missing any point. I didn’t say anything about borrowing to buy back shares (although I do feel the law should be changed so that foreign earnings can be repatriated), I was critical of the whole idea of buying back shares.

You say buying shares back makes sense, but offer no justification. Should we just accept that because you’re from Oregon?

Posted by KenG_CA | Report as abusive

My biggest grumble with stocks buybacks is that they are too often a faux display of confidence, when a **real** display of confidence would be senior management materially investing their OWN money in buying company stock.

Case in point, you often see the laughable scenario where Company X authorizes buybacks of $600M worth of company stock, and then senior management either buys no stock or a ridiculous token amount. It’s almost a reverse indicator, signaling: A) we’ve run out of ideas; and B) we are moving to the optics phase of running the business.

Posted by hypermark | Report as abusive

“Many shareholders, especially individual shareholders in high tax brackets, dislike dividends, because they’re taxable income.”

How relevant is this now that the plutocracy has managed to insert the “qualified dividend” into the tax code? I find that 80%+ of my dividends are qualified, and so effectively cap gains.
OK, the dividend forces you to REALIZE capital gains in a way that a stock buyback does not, but the cap gains rate is low these days.

Relying on (IMHO) weak arguments like these is precisely why people regard stock buybacks under most conditions as a way poor managers can goose the numbers to their advantage.

Posted by handleym99 | Report as abusive

Felix, test your take against David Stockman’s, who, after summarizing how Cisco and ExxonMobil have used stock buybacks to enrich senior management, writes:

“The truth of the matter is that the management and board of … most public companies, are addicted to share buybacks. Buy-backs are the giant prop which keeps share prices elevated, existing stock options in the money and the dilutive impact of new awards obfuscated. They are also the corporate laundry where Federal income taxes are rinsed out of top executive compensation through the magic of capital gains.”

David Stockman, “The Great Deformation,” p. 458.

Posted by TBV | Report as abusive

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