American companies have been spending wildly lately, but that cash isn’t being used for R&D or innovation. Rather, it’s being spent to buy up gobs of company stock.
In November 2016, Goldman Sachs’ chief equity strategist David Kostinestimated that, in 2017, S&P 500 companies will spend $780 billion on buybacks — a new record.
For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed. And it’s obvious why Wall Street loves them: Buying back company stock can inflate a company’s share price and boost its earnings per share — metrics that often guide lucrative executive bonuses.
As Reuters wrote recently, “Stock buybacks enrich the bosses even when business sags.”
Still, even politicians like Warren don’t really seem to grasp how to effectively reign in buybacks.
Make them illegal? Regulate them?
Here’s a suggestion that I believe everyone can agree on: Give shareholders the right to vote on buybacks.
That’s right. Every time executives want to authorize a buyback, this decision should go to a proxy vote. In my mind, this rule should have been implemented long before the buyback binge even got started.
Now, you might be wondering, what would give shareholders the right to vote on buybacks?
Well, to start with, there’s plenty of precedent for it.
All cash on a balance sheet is shareholder’s property. In the history of business, I can’t think of any precedent for taking excess cash (which technically belongs to shareholders) out of the corporation and swapping it for a different kind of property, without the owner’s explicitly signing off. And specifically in this case, that cash is being swapped for an inherently more risky asset.
So, if the shareholders decide that the company stock is undervalued and the best use of that cash is to send it back into the market — sure, let them vote it through. But if they decide it’s not the most prudent use of company cash, then protect it. Use that cash for R&D, hoard it, or distribute it to shareholders and allow them to decide. It doesn’t matter. Shareholders have a right to have a decision in this process.
Why do I care? I’m a forensic accountant, and I have been in investment management since 1990. I pick stocks for myself, and for my clients. And I want to own great, cutting-edge businesses that use their capital in the right way. But way too often, I’m seeing shareholders get screwed over because of stock buybacks.
Consider the case of American Airlines, a company two years out of bankruptcy, facing down $19 billion in debt — and continuing to buy back billions of dollars worth of company stock.
You have to ask: Is that really the best use of company cash? Either way, shareholders should have a say in that.
Another example: Hewlett-Packard. In the last decade, the company has invested $47 billion in stock buybacks — which is nearly double the company’s current market cap. That risk is senseless. HP knows they are facing existential threats from upstart competitors, but instead of paying out dividends or letting cash accrue on the balance sheet, HP is choosing the riskiest option.
As a result, shareholders didn’t get a dime of that $47 billion in cash.
Now, I have some theories on why stock buybacks have gotten so out of control. Mostly, I think it’s because we’re in a period of massive technological disruption. New industries like cloud computing, electric cars, and streaming video are rapidly changing the world. But in my opinion, older companies like HP have been too slow to adapt, and rather than investing in research and development (or simply holding onto cash) the corporate boards of legacy businesses are bolstering stock prices the only way they know how: playing defense and buying back stock.
It’s gotten so bad that I literally keep a “Hall of Shame” list of buybacks offenders on a whiteboard in my office, and the list grows every day. Buybacks are supposed to be funded with excess cash that the business doesn’t need for innovation or expansion. But Rule 10b-18, the rule proposed in 1982, gives executives total power (and a blank check) to determine their own incentive-based compensation
Now, it should be mentioned that I don’t believe that all buybacks are bad. In some cases, a company may truly have an undervalued stock, and using excess cash to repurchase shares is actually a prudent, if not potent use of that shareholder cash. But right now, without shareholder approval, corporate boards freely swap a safe asset (cash) for a risky asset (stock).
In the end, it’s not the executives who get hurt. It’s the rank-and-file employees, as well as the investors who will see their pensions and 401(k)s decline. What I’m proposing is pretty straightforward: Not that companies should be prevented from authorizing stock buybacks, but that decisions to do so should simply go to shareholders for a proxy vote.
Where’s the controversy in that?