Capitalisn’t: Are Stock Buybacks Evil?

Luigi: Are stock buybacks evil? A lot of politicians seem to think so. And not just the usual Sen. Bernie Sanders, but also Chuck Schumer, the senator of Wall Street. They cowrote an op-ed in the New York Times this year, calling for a limit on corporate buybacks.

Speaker 2: The senators say companies should pay their workers better wages and provide better benefits. They plan to introduce legislation requiring corporations to, and here I’m going to quote, “address needs of workers and communities before the interests of wealthy stockholders.”

Kate: On the surface, it’s easy for a lot of people to see the logic here. At a time when wages are low, why should corporations be giving themselves a bonus? But most economists would say that it’s more complicated than you think.

Speaker 4: This is basically legislators saying, “We know better how to deploy corporate capital than the managers in the business.” Now, let’s look to history again. Where has that led people?

Speaker 5: I think we paint with these broad brushes when we tend to have these conversations and you forget about some of what it goes back to.

Luigi: Who has got it right this time?

Kate: I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales from the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

On this episode, we’re going to discuss stock buybacks. What are they? How long have they been around? Do insiders use them to drain profits from companies? And, of course, should we ban them or not?

Kate: Before we get into the controversy about stock buybacks, we should first explain what a stock buyback is.

Actually, we should first explain what a stock is. I know that a lot of people are smart. I know that a lot of people have money invested in the stock market through their 401(k)s or their brokerage accounts. But I think there are still a lot of misconceptions about what a stock is.

I like to give the example of a pinball machine. And the reason I like to talk about this is because one of Warren Buffett’s first investments, when he was a teenager, is that he bought a pinball machine.

Luigi: Do you know The Who song, “Pinball Wizard”?

Kate: Luigi, I think that’s the coolest thing you’ve ever said.

Luigi: I actually saw that movie many, many years ago, Tommy. I’m surprised. This is probably one of the few things we have in common, Kate.

Kate: What? That we listen to The Who?

Luigi: Yeah.

Kate: I think that might be true.

Let’s say that you want to buy a pinball machine and you want to put it in a bar. And let’s say you go in on this with a bunch of friends for $10,000, so you each chip in $1,000. You put it in a dive bar, and eventually the pinball machine starts making money. People put quarters in it, and at some point you can empty the tray of quarters and you’ve got yourself some cash.

You and your friends realize that this is a profitable business. You guys are making a lot of quarters, more than you expected. And at some point, you’re like, “You know, maybe we should use the money that we’ve accumulated and we should actually buy another pinball machine in another bar.”

You don’t want to have to talk about this all the time because you’re busy, you have jobs and stuff. And so you designate somebody to make this decision for you. You designate Joe, because he’s not working right now and he has a lot of time on his hands.

Joe decides—and let’s call him the CEO—to take the money that your pinball machine has accumulated. And rather than distribute it to you guys, who own the pinball machine, he decides to buy another pinball machine in another bar. And everyone collectively now owns these two pinball machines.

The stock is the ownership in a company. A company is a business that makes money. Those quarters in the pinball machine, that’s the cash that the company has generated. And the CEO is Joe, who’s making a decision about how to use that cash and whether you guys collectively should invest in more businesses, more companies, or whether that cash should be paid out to the people who own the company, the shareholders.

Here’s the thing. There are different types of payouts.

One is just you guys get quarters, right? Everyone gets one-tenth of the quarters that have accumulated over time. That would be called a dividend.

Now, another form of companies paying cash out to shareholders is a stock buyback. Let’s say, rather than taking that cash and distributing it evenly to the owners of this pinball machine enterprise, let’s say you repurchase one of the shares.

Pretend that Sally wants to be out of the business. She’s too busy. Well, first of all, you have to come up with the value of the company. You take the cash that you’ve accumulated over time. You pay back Sally her fair share of the company, and so now she’s out. Any future money that that the pinball machines make, the cash per person increases, or the earnings per share in stock-market terms. But you also have less cash accumulated within your firm, right? You had to pay her back. And so now there are less quarters within your company, less cash.

In this sense, in the way that the cash has been distributed, or in the sense that the cash has been distributed out of the company, a stock buyback is sort of similar to a dividend. In fact, in many senses they’re equivalent.

Luigi: One question is, why do you want to return the cash to the shareholders if you can expand your business of pinball machines?

In fact, if it is true that you have a great opportunity to expand and buy a pinball machine in every other bar, then that’s a great way to use your money. But eventually you might be running out of places to put pinball machines. Or a new technology may come along, video games, and you know what? You might not be the best guy to run the video games.

That’s one of the reasons why it’s important to return the money to the shareholders. It’s to let the capital market decide where the money is allocated. Because if I am in the business of pinball, I’m a pinball wizard. The only thing I love is pinball. I will think that the future is pinball, even if the future is video games or virtual reality. If I keep investing in pinball when the world has moved by, I’m wasting money.

More often than not, companies don’t have a good control system to avoid this waste. And the way to return the money to the shareholders is the best way to ensure that money is invested in the most profitable opportunities for shareholders at large.

Kate: If dividends and buybacks are pretty equivalent because they’re just a form of a company taking cash that it’s accumulated, that it no longer has a need for, and paying it out to shareholders, then what is the difference, right? Why would people prefer one or the other?

Really, it comes down to taxes. If a company pays out a dividend, then you have to pay taxes on that immediately, right? You received some cash, you have to pay taxes on that. However, in the case of a stock buyback, some people will sell back their shares to the company, and some people will hold onto their shares. If you continue to hold onto your shares, people would rather pay taxes later rather than taxes now. This is an argument for why share buybacks are preferred to dividends.

Luigi: Actually, it’s even better: pay taxes never. There are loopholes that allow you to completely avoid the capital-gains tax.

For example, if you leave a stock to your descendants or you give it to charity, you never pay capital-gains tax. By adding a huge capital accumulation and then donating your stock to a foundation or leaving it in inheritance for your children, you completely avoid any tax.

But to be honest, we have to recognize that as financial economists, we do not have a very compelling reason for why companies pay dividends and why dividends are so sticky. But de facto, we know that companies don’t like to change dividends very much. Dividend payouts, and especially dividend levels, are very sticky over time, while stock buybacks are extremely flexible. There is another advantage that buybacks have over dividends, and it’s exactly the flexibility.

But the interesting fact is, historically, companies were only paying dividends. The first major burst of buybacks happened in the 1970s, thanks to, of all people, Richard Nixon.

Richard Nixon: The time has come for decisive action, action that will break the vicious circle of spiraling prices and costs. I am today ordering a freeze on all prices and wages throughout the United States for a period of 90 days. In addition, I call upon corporations to extend the wage-price freeze to all dividends.

Luigi: Kate, you’re too young to remember. But Richard Nixon imposed not only wage controls and price controls but also dividend controls. OK? This is to say how far we’ve moved, because a Republican president decided that to fight inflation, you should block everything.

And so, companies say, “Oh, wait a minute. We have a dividend freeze, but we can actually experiment with something else.” Ergo, stock buybacks. And so, they started to do buybacks and they saw that it was working quite well.

In the ’80s, the phenomenon started to become big and then has been growing ever since to the point now that more money is paid back in aggregate to the shareholders in the form of buybacks than is paid in the form of dividends.

Kate: Exactly. To put some numbers on that, if you’re looking at the S&P 500 in 2018, about $1.2 trillion of cash was returned from stocks to shareholders, and roughly two-thirds of that was in the form of buybacks, whereas one-third was in the form of dividends.

This is basically in line with the buyback-to-dividend proportion that’s been in place for the past 20 years, with the exception of 2009.

Luigi: A lot of politicians are now screaming against buybacks. What they claim, what Chuck Schumer and Bernie Sanders claim, is that the reason why companies don’t invest is because they buy back stock. The reason why they don’t pay higher wages is because they buy back stock. And the reason why America is not growing as fast as it used to is because companies buy back stock. Is there any evidence of that?

Kate: Well, it depends on what you call evidence, right? If you’re just looking at a pure historical correlation, then the period in which wages have become more stagnant has coincided with a period in which stock buybacks have become more popular.

Luigi: It’s also coincided with me getting older, but I don’t think I’m responsible for that.

Kate: Actually, I think you might be responsible for all of the problems in the world’s economy.

Luigi: My age, certainly—

Kate: Exactly, yeah.

Luigi: No, but this was a cheap way to say that sort of correlation is not a proof of causation, especially when we look at the overall time trend, because there are a lot of things that trend together. Pollution is trending together. Should we necessarily make a causal interpretation between the two?

But more seriously, if you look cross-sectionally, there is a correlation between companies investing less and paying more in corporate buybacks. But the direction of causality is most likely to be the opposite, in the sense that if I am in a business without much of a future, I don’t want to keep investing.

Until the development of vaping, companies that were in the business of tobacco did not have a bright future. But they were still making a lot of money selling a product that makes you addicted, so a very good product to sell with very high profit margins. If I am an executive of Phillip Morris in 2000, should I keep investing in selling more cigarettes around the world? Or should I return the money to the shareholders?

Kate: Yeah, I think that we shouldn’t be incentivizing companies to make bad investments, right? We shouldn’t force companies to always keep cash within the company, because eventually that might incentivize them to invest in hole-digging projects or dumb pinball machines or cigarettes that no one’s going to smoke. Actually, you know, let’s just get rid of cigarettes altogether. But anyway, I digress. The point is that we don’t necessarily want to force companies to invest when we know that those investments aren’t good.

The alternative, if companies pay back cash to their shareholders, that can be a good thing, right? It means that the shareholders will use that cash to buy more stuff if they want. Or they’ll use that cash to invest in different companies that are better and growing faster. And that’s what we want in order for capital markets to direct resources to the right places.

Luigi: I think it’s important to understand why politicians push for this ban on buybacks.

Because if I look from the perspective of the existing tobacco workers or the existing tobacco producers, trapping the equity there, trapping the cash inside the tobacco companies, is good because it’s making it more likely that I will keep investing in tobacco and that will inevitably benefit tobacco producers and tobacco workers.

And even if I don’t invest in tobacco, I will probably make other investments that are related to the tobacco business. But I will still provide a career to the existing employees.

It is very much a rent-seeking argument of existing workers that want to protect themselves and protect the existing producers at the expense of innovation and efficiency in society at large.

Kate: What about this argument that, OK, let’s pretend it has nothing to do with innovation and new investment. It’s just that workers should be paid more. Every time a company has enough cash accumulated and it’s ready to pay a dividend or engage in a stock buyback, it should also give all workers a raise.

Luigi: This may actually have a perverse effect, because if I’m forced to pay workers more, that will increase my cost of the workforce and will push me to substitute more with machines.

At the end of the day, forcing me to pay the labor force much more might lead to faster automation and more reduction in the workforce. I’m not so sure that this is exactly what Schumer and Sanders want.

Kate: Look, I agree that wage stagnation is a huge problem in society. And the bargaining power lies too much, increasingly and now excessively, in the hands of capital rather than labor. And we’ve seen that because of the secular decline in union participation.

To me, the whole stock buyback story seems like kind of a roundabout way of addressing this, right? If we’re worried about wages and we’re worried about workers, let’s try and give them more bargaining power. Let’s try and go back to union participation.

But to enact a law that actually pegs buybacks to wages, I think is sort of a clunky way of addressing this, and as Luigi mentioned, could lead to some backfiring.

Luigi: Yeah, I agree 100 percent with you. It’s a bit like saying we know that healthcare in the United States is very expensive. One of the elements is that doctors in the United States tend to be paid more than in other countries. Is the solution forcing a reduction mandate that all doctors are paid half of what they’re paid today? No. That would be a crazy way to go about fixing the problem. We need to introduce more competition in the system, and we need to introduce a lot of other things before we go down that path.

And I think that the same is true for wage stagnation. I don’t think the way to fix wage stagnation is to force companies to invest in bad investments.

Kate: And I think that the most practical proposal that certain people have put out there in terms of buybacks and dividends, buybacks in particular, is that, all right, let’s not try to link them to anything. But let’s just put a limit on how much companies can pay out so they’ll be forced to invest more or pay higher wages.

I think the practical reality of what would happen is that if companies could only pay out a limited amount of their cash or they could only buy back a limited amount of stock, either they would just pay more dividends if that were allowed, or if dividends were also restricted then they would just sit on the cash, right? There’s nothing stopping a company from just having a bunch of cash in the bank account. I mean, in reality they would invest it in Treasuries and stuff. But essentially, they would be sitting on low-yielding assets, and that would make investors angry eventually, because like I said, they could have paid that out to investors who would put that to better use.

Luigi: Actually, I would push the argument even further. If I know that I might be constrained in my ability to return cash to investors in the future, I might start to do it earlier. At a time in which I still have valuable investment opportunities, I will start doing buybacks because I’m substituting for buybacks that I cannot make in the future. Rather than increasing investments, this limit might reduce investments.

Kate: That’s a good point.

Luigi: Do you think there is any validity, if you work hard, is there any validity to the Schumer and Sanders argument?

Kate: Unfortunately, I think it’s the sort of thing where they’re right in spirit but they’re wrong in application. We should be worried, I think primarily, about the stagnation of wages. As I said, I think there are better and more direct ways of addressing this by empowering workers directly.

And when it comes to innovation and investments, I think that we should be a little bit concerned about the fact that these seem to be slowing down. But as you mentioned, I think the causality goes the other way, that we’re slowing down in the opportunities that are available to us. And that’s the reason that companies are engaging more in buybacks, not the causal direction that they claim.

Luigi: In preparing for this episode, I was reading the literature, and the following occurred to me.

Let’s take for granted that the long-term return that we see after buybacks is correct. There’s a debate over whether this additional return represents a risk or whether it really is a signal that companies buy their stock when the stock is undervalued.

Imagine that I am, for a second, a CEO that really cares about the value of my shareholders. And I see that the stock is trading at $20, but I know that the true value is $30. Why don’t I try to buy back the stock in order to bring it back to the true value? I think there is some evidence in that direction. So, let’s assume that this is the case.

I think the argument that the two senators make that this might discourage investments is not that crazy. Because imagine that I know that my stock is really undervalued and so I can make a return by buying the stock of, say, 30 percent a year. While if I can make a real investment, I make only a return of 20 percent per year. So, I give up a good investment—20 percent is a fantastic investment—for a better financial investment.

Now, from a societal point of view, that is by and large a transfer, because I buy cheap from the existing shareholders, and that benefits the rest of the shareholders but is basically a transfer. While the additional investment that creates value is a real addition to the capital that exists in the country. So, there is a substitution.

Now, this substitution will not take place with dividends. Why? Precisely because dividends are not that flexible. If I know that I have to pay a continuous stream of cash, then I’m not going to speculate on my own stock, because I cannot. I have to pay out the same amount all the time. But if I’m allowed to speculate on my own stock, I divert part of the cash that I would have invested in real investment for that.

I think that the argument, I have to say, is a bit more sophisticated than the one that the two senators use. But I don’t think it’s completely out of the feasible set.

Kate: Let’s move on to the argument that buybacks are a form of insider trading. It’s a way for executives and CEOs, who are the ones who make the decisions about whether or not the company should buy back stock, to opportunistically sell their shares at the same time that the company is buying back stock or right after the company has announced a stock buyback, when presumably the stock price is a little bit higher.

Is it possible in theory that CEOs are using stock buybacks to manipulate share prices for their own personal gain?

Luigi: I think it is possible, definitely. And it’s more than that.

One of the commissioners of the SEC, Robert Jackson, actually published some research showing that there is a remarkable correlation between the day insiders sell stocks and the day the company is buying stock. There is a clear potential for abuse and it would take very little for the SEC to force a bit more disclosure and avoid the problem.

I think that in this case, we don’t need to ban corporate repurchases like Sen. Schumer is suggesting, but having a little bit more transparency seems like a low-hanging fruit.

Kate: I agree. And in addition to Commissioner Jackson’s research, there’s also much older research by Christine Jolls, who’s a law professor at Yale University, who found that there’s a remarkable correlation between the period of time when executives were increasingly compensated with options and when buybacks became really popular. Not only that, but within each company, the ones in which executives are more compensated with options are the companies that use buybacks increasingly or use more buybacks and dividends.

The whole idea behind options is that if you’re compensated with an option and a company pays a dividend, the share price drops when you pay a dividend. And so that makes your option less valuable. If you’re a CEO and you have a bunch of options, why would you make a decision that makes your share price drop?

Luigi: Yeah, it’s basically a mechanical reason why CEOs compensated with stock options don’t like dividends. But again, it’s a little bit silly, because compensation committees can very easily adjust stock prices for dividends. So, it’s just out of laziness from the compensation committees. It’s not that this cannot be easily fixed.

Kate: That’s true. But it is sort of puzzling that this has been known for a while and yet we haven’t seen compensation packages change that much.

Luigi: Yeah, that’s true. I think that compensation committees are pretty lazy.

One factoid that is important to know is that whenever a stock buyback is announced, the stock price goes up by roughly 2 percent, at least in the United States. But then, in the two or three years afterward, there is a positive drift, so that the stock on average keeps growing more.

One of the objections to stock price manipulation is that, after all, these executives are pretty dumb. Because imagine that I time my purchase immediately after an announcement, it’s true that I gain 2 percent if I bought the stock before, but also I lose 8 percent on average in the next three years. So, if they are doing this manipulation before they are put in jail, they should be fired because they’re incompetent.

Kate: I’m not sure that I entirely subscribe to the idea that that’s a sign that CEOs are dumb. Because if you’re a CEO, a lot of your compensation is in the form of the stock of that company and, in many cases, options of that company, which means that you have a lot of your wealth tied up in this one enterprise. And the first thing that financial economists will tell you is that you should diversify, right? You’re taking on too risky, too concentrated of a position.

And even though it makes sense for the board of directors, for shareholders, to compensate CEOs that way so that they make decisions about the company that are aligned with the long-term interests of that company, you as a CEO, as soon as you get stock, unless you have really good positive inside information about the company, from a diversification perspective, it makes sense that you would want to sell as soon as you can.

Luigi: I think you’re absolutely right on this point, Kate. There is a big difference between a 2 percent return in one day and an 8 percent return on average over a year. Because the standard deviation, the variability around that 8 percent is huge.

As a result, a CEO is very much tempted to sell immediately after a 2 percent return and is much less tempted to hold on, because as you said, there’s a lot of risk involved in that 8 percent. And already the CEO is not particularly well-diversified, and so holding on to enjoy that extra return might be quite expensive in terms of variability.

Kate: I also think it’s worth discussing why a stock price should even increase upon the announcement of a stock buyback, right? It’s not obvious that it should increase. If you’re taking cash out of the company and you’re just repurchasing shares in the open market, then it seems like the stock price shouldn’t change that much, right? You’re not actually ...

One of the common misconceptions about stock buybacks is because there are fewer shareholders, that increases the value of each share, because future earnings go to a smaller number of shareholders. But you also have to keep in mind the company is using their own cash to repurchase those shares. And so any concentration of ownership is offset by the fact that the cash left the company. And so, absent other factors, it’s not clear necessarily that there should be a stock price boost upon the announcement of a buyback.

Luigi: Yeah. In the finance jargon, we say that if there are no capital-market frictions, if markets are perfect, then of course a buyback should have no impact on stock prices. However, in reality, there could be two reasons why the stock price goes up.

The first one is that investors are afraid that managers may spend that money on investments that are not worth it, also known as wasting that money. In the pinball example, if I am a pinball lover, I keep buying pinball machines at the time of video games or virtual reality. And that would be a waste. If I returned that money to shareholders. If I announce that I’m going to return more of that money to shareholders, that’s good news for everybody. That goes under the rubric of agency theory because it assumes that managers are not necessarily doing the right things for the shareholders.

Then there is a much more heterogeneity of valuation perspective that says I start to buy the stock from people that have the lowest valuation of the stock. So, imagine that I tender at the current market price. The first ones to tender are the people who don’t think that the stock will appreciate a lot. And so—

Kate: By the way, tender means to sell back.

Luigi: Yes, sorry. And so, by buying out the less-committed or the less-bullish investors, I am left with the most-bullish investors that will value the stock more.

Kate, if you were king for a day, how would you fix the problem? I should say, queen for a day.

Kate: I’m OK with king.

There are different problems, right? One is the insider gaming, wouldn’t say trading, but insider-gaming problem. And then the other one is stagnant wages and underinvestment.

I think that the literature suggests that the way that managers are compensated has something to do with the timing and incidence of stock buybacks, which isn’t great. But I also think that it’s not a huge amount of money that they’re getting, right? Maybe they’re getting a 1 percent boost. Over time, this might accumulate, but I don’t think that this is causing society’s problems. Maybe it’s something that the SEC should be somewhat concerned about, but I don’t think that it’s ruining America.

On the underinvestment problem, I think that it’s an unfortunate reality of where we are today. I don’t know necessarily that any of these plans that people have to force companies to invest are actually going to generate more growth. I think that the way that we need to generate more growth is to give poor people more money. And, like I said, on the wages, I think laborers need more power.

I guess what I’m trying to say is that the gaming side of it, I think is not that important. And the other big issues in our economy should be addressed by other means and not stock buyback policy.

What about you, Luigi? Do you think that buybacks are a capital-is or a capitalisn’t?

Luigi: I think it’s probably a capital-depends.

No, I’m 100 percent with you on the SEC ruling. I think that it takes very little for the SEC to bring more transparency. It’s not going to change the world, but I think it’s important to make people feel that they are all treated in the same way in the stock market. This feeling that, oh, if you’re an executive, you’re treated in a particular way, and if you’re not an executive, you’re treated a different way, so that us pension-fund holders are screwed all the time by insiders, it’s not a good way to run a society, and it’s not a good way to run a stock market. And in that sense it takes very little for the SEC to fix their rules. It’s pretty embarrassing they have not done it yet.

When it comes to the bigger fundamental issues, clearly stagnant wages are not going to be resolved by stock buybacks. I don’t think that banning stock purchases is the way to go. What I find funny to some extent is to this day they are tax-favored, less than they used to be, but they’re still tax-favored. I don’t see any reason why they’re tax-favored.

I am very skeptical of using tax policy to fix every problem. But on the margin, if I had to choose whether to make them tax-favored or tax-disfavored, I would make them slightly tax-disfavored.

Kate: Luigi, what if we banned buybacks and dividends? How would that work?

Luigi: The stock market value would go to zero.

Kate: Yeah, I think it’s important to understand that if you own a company, then there has to be some means of getting cash out of that company, right? Let’s say you bought that pinball machine, but you were never allowed to empty its trays. What would its value be? Zero.

At the end of the day, I don’t see buybacks as a good or an evil. It’s just something that’s supposed to happen, right? If you bought a pinball machine, you would expect that eventually you’re going to take some of those quarters out of the pinball tray. If you were not able to do that, that wouldn’t make any sense. But it’s also not a huge benefit to society. It’s just the definition of a stock. It’s the definition of ownership, that when your company makes money, eventually you should be able to get that money.