Are share buybacks really a bad thing?

Markus Muhs - Mar 02, 2021
This is starting to come up again in political discourse. I insist, and will tell you why, share buybacks are objectively a good thing, and Uncle Warren agrees!
Okay, I’ve gotta say something about stock buybacks, as this is starting to creep up in the news-cycle and political soundbites again. Actually, it was this video that popped up in my Twitter feed that sparked this (initially retweeted by AQR’s Cliff Asness with a simple comment of “No”).
 
 
First of all, I won’t hide the fact that I’m politically right of center, but I do actually respect Senator Warren greatly. I wish we had someone like her in Canada to stand up to the big banks as she has in the past. She's held a certain large American bank to account for their fake accounts scandal, leading to the ouster of its CEO, whereas here in Canada our major banks go off scot-free despite engaging in largely the same practices.
 
That aside, this post is about stock buybacks, and I want to provide a bit of education around them. I don’t think being for or against them is even that politically polarized right/left, as I think there are populist viewpoints on both sides opposing buybacks for some reason.
 
The thing is just, I wish those who oppose share buybacks would educate themselves a bit more about corporate finance before expressing such views. Saying “companies only do share buybacks to manipulate their share price” is completely ignorant. Perhaps a view of “share buybacks in place of dividends circumvent a level of taxation that unfairly benefits only the wealthiest” might be more appropriate. 
 
Let’s take a step back and remember how shares came to be in the first place. We’re actually seeing more of this in recent years than we were for much for the first two decades of this century. As shares get created through Initial Public Offerings (IPOs) and secondary offerings, they too can later be bought back and “destroyed”. If not, we’d end up with a near-infinite proliferation of shares, would we not?
 
Corporations can finance their growth in a number of ways. 
 
One of the simplest and most common ways is the issuance of bonds; effectively borrowing money from investors on which they pay interest, eventually needing to repay the principal. 
 
The other big one is the issuance of common stock; selling a piece of the company and entitling the shareholder to an ownership stake, to the company’s future profits, and possibly paying them a dividend along the way. Unlike a bond with a maturity date, a common share of a company is effectively a perpetual security with no obligation from the company issuing it that it will ever be paid back. We shareholders are okay with that, because we generally want to own the company, or otherwise can sell our shares on the open market to someone else who does.
 
Growing companies issue bonds and stock when they need capital, often before they even have any cash flows. Often bond issuance isn’t even an option for smaller start-ups, as their future cash flow prospects are way too risky for anyone to want to take the chance lending them money, so all they can do is issue shares.
 
As companies mature and generate cash flows, they then find themselves in the enviable position of having to decide what to do with their net cash flows. 
 
A Cash Flow Statement has 3 main parts to it:
 
A tabulation of Operating Cash Flow: Usually just taking the bottom line figure off their Income Statement and adding back non-cash related accounting deductions like depreciation and amortization to more accurately depict the actual cash the company has taken in (I find this figure is usually much more relevant than net income, as it de-pollutes a company’s net income of various accounting shenanigans).
 
Cash Flow from Investing Activities: Here, generally, the company tabulates money reinvested into itself. It may also include the sale of assets or other investing activity, should the company be investing its cash equivalents in marketable securities and whatnot.
 
Cash Flow from Financing Activities: Here a company tabulates what it has done in terms of financing. Effectively making their ends meet, whether that be the issuance of stocks or bonds to finance an operating cash flow shortfall, or investment activity from the sections above, OR… and this is what I’m getting at here… repaying liabilities from previous “cash in” financing. I’m not sure if “liabilities” is the perfect accounting term to also encapsulate that in addition to loans and bonds, companies also have a liability to common shareholders. Here, in this section, they tabulate the dividends paid to such, as well as repurchasing (effectively repayment of) shares.
 
How a company manages all of the above is usually the job of a company’s Chief Financial Officer (CFO) and/or whatever leadership is in place of the company. A lot of thought usually goes into this, and thankfully we don’t live in countries where it is determined by government fiat. 
 
Sometimes it’s a tricky balancing act for a start-up company, as in “how do we finance our burn rate and investing activities in a way that isn’t too detrimental to our shareholders?” 
 
Those mature companies dealing with a lot of net cash flow coming in from operating cash flow also have a fiduciary duty to their shareholders to make the best financial decisions with that net surplus cash, whether that be to:
  • Repay bank loans or buy back bonds (if applicable)
  • Invest in growth of the company (this also can’t be entered into blindly, lest a company malinvest its capital)
  • Stockpile cash (perhaps this strengthens the company balance sheet, but it generally is the least effective use of capital in a low-interest environment)
  • Initiate or raise dividends to shareholders: often undertaken if none of the above makes sense. From a politically left perspective probably could also be seen as mostly just enriching the shareholder, however, it does lead to additional tax revenues for governments.
  • Buy back shares: effectively electing to repay a completely non-obligatory debt to the shareholder.
 
Again, it should be emphasized that companies that pay high dividends or engage in share buybacks typically do so because they don’t have much other use for the cash. They might have at one time in the past required a lot of capital and borrowed from shareholders, and now they don’t anymore so they’re repaying shareholders.
 
I realize the biggest argument against buybacks is that companies should invest in their own growth, creating more jobs and economic activity. In a perfect world, all companies would do this—ALL COMPANIES WANT TO DO THIS—but depending on what business a company is in, how mature the industry, or other prevailing market forces, this isn’t always the best course of action, and again it should be up to the smart CFOs and other company leadership of the company, not government decree.
 
 
In his latest shareholder letter, Warren Buffett talks about share buybacks on two levels: both of his own company, Berkshire Hathaway (BRK), as well as one of their biggest investments, Apple. 
 
It’s been known for a while that BRK has built up a pretty massive cash hoard. There has always been anticipation that Buffett and Munger would initiate another “big splash” investment (he alluded to it in his 2018 letter, if I recall), purchasing an entire company as they did Burlington Northern Santa Fe Railroad some years ago. Not having found any great deals of late, not having been able to move quickly and confidently enough to buy a lot of stocks during the spring 2020 market swoon, and also determining that the market was undervaluing BRK shares, Buffett, presumably along with other BRK management, decided to buy back $25 billion of their own shares.
 
While I don’t think it’s mentioned in his latest letter, I have heard Buffett talk about investors in BRK in a way that in today’s social media investing parlance can be translated to “paper hands” and “diamond hands”. He prefers investors in BRK (whether in the $380K original never-split A-shares, or the more commonly available $250 B-shares) to be diamond hands, owning those shares for the long term. Buybacks actually give him the opportunity to thin the herd of paper hands, as diamond hands will ignore a buyback offer (usually offered to all existing shareholders at a slight premium to market price), while paper hands might jump on it, dump their shares, and move on to the next trade.
 
From the investor perspective, Buffett mentions BRK’s Apple holdings in this latest letter. Apple too has been engaging in buybacks; while they’re a high-growth company, revenues from their popular products and platform well exceed their ability to reinvest into their own company. Along with BRK, Microsoft, and Alphabet (all companies most accused of buybacks), Apple is one of the cash-richest companies in the world. Buffett mentions how despite having sold $11 billion worth of Apple shares in 2020, their stake in the company has actually GROWN from 5.2% to 5.4% thanks to Apple’s buybacks.
 
In summation, I don’t think I’m expressing a politically-charged or overly capitalistic viewpoint here that share buybacks are logical and should generally be encouraged. Companies—while they’re not required to—effectively pay back shareholders who provided capital during their growth phase, and those shareholders who intend to be long-term investors in a company benefit by then owning a larger stake.
 
It is good, effective, use of capital, and the only real losers are the government who would probably prefer companies pay more dividends—to generate more tax revenue in the present—than to have them effectively create more capital gain taxes in the longer-term. I think governments tax companies and individuals enough as is, and it should be noted that the cash that companies have available for share buybacks generally is already after-tax money to the corporation.
 
Lastly, it should be noted that none of the cash that companies spend on share buybacks disappears into the ether. Those who owned shares in company X and had those shares bought back, whether they be individual investors or institutional funds, now have cash which they can reinvest into something else. Company X had no good economic use for that cash, and was just stockpiling it in their Irish subsidiary anyway, and it was returned to investor hands. Investors can then make the best economic decision for themselves, whether to invest in some new company or even to simply spend that money (also creating economic activity).
 
Share buybacks are a win for everybody.
 
 
Markus Muhs / CFP, CIM
Investment Advisor & Portfolio Manager