Why do Firms buyback their Shares? Causes and Consequences.

Why do Firms buyback their Shares? Causes and Consequences.

 

From Stock buybacks: From retain-and reinvest to downsize-and-distribute

Since the late 1980s, in the name of “maximizing shareholder value” (MSV), U.S. corporate distributions to shareholders have exploded. Dividends are the traditional mode of providing a stream of income to shareholders who, as the name says, hold on to a company’s stock, thus supporting stock-price stability. In contrast, stock repurchases, in which a company buys back its own shares from the marketplace, thus reducing the number of outstanding shares, provide short-term boosts to a company’s stock price, thus contributing to stock-price volatility. Until the mid-1980s dividends were the overwhelmingly predominant form of distributing cash to shareholders. Since then, however, even with dividends on the rise, stock buybacks have added substantially to distributions to shareholders.

Over the decade 2004-2013, 454 companies in S&P 500 Index in March 2014 that were publicly listed over the ten years did $3.4 trillion in stock buybacks, representing 51 percent of net income. These companies expended an additional 35 percent of net income on dividends.5 And buybacks remain in vogue: According to data compiled by Factset, for the 12-month period ending December 2014, S&P 500 companies spent $565 billion on buybacks, up 18 percent from the previous 12-month period.6

Stock buybacks are an important part of the explanation for both the concentration of income among the richest households and the disappearance of middle-class employment opportunities in the United States over the past three decades.7 Over that period the resource-allocation regime at many, if not most, major U.S. business corporations has transitioned from “retain-and-reinvest” to “downsize-and-distribute.” Under retain-and-reinvest, the corporation retains earnings and reinvests them in the productive capabilities embodied in its labor force. Under downsize-and-distribute, the corporation lays off experienced, and often more expensive, workers, and distributes corporate cash to shareholders.8 My research suggests that, with its downsize-and-distribute resource-allocation regime, the “buyback corporation” is in large part responsible for a national economy characterized by income inequity, employment instability, and diminished innovative capability – or the opposite of what I have called “sustainable prosperity.”9

 

 From Buyback Quarterly – Factset/December 2016

buyback2

 

From Stock buybacks: From retain-and reinvest to downsize-and-distribute

buyback

Profits Without Prosperity

 

Five years after the official end of the Great Recession, corporate profits are high, and the stock market is booming. Yet most Americans are not sharing in the recovery. While the top 0.1% of income recipients—which include most of the highest-ranking corporate executives—reap almost all the income gains, good jobs keep disappearing, and new employment opportunities tend to be insecure and underpaid. Corporate profitability is not translating into widespread economic prosperity.

The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.

The buyback wave has gotten so big, in fact, that even shareholders—the presumed beneficiaries of all this corporate largesse—are getting worried. “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” Laurence Fink, the chairman and CEO of BlackRock, the world’s largest asset manager, wrote in an open letter to corporate America in March. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”

Why are such massive resources being devoted to stock repurchases? Corporate executives give several reasons, which I will discuss later. But none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.

As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are instead devoting most of their companies’ profits to uses that will increase their own prosperity—with unsurprising results. Even when adjusted for inflation, the compensation of top U.S. executives has doubled or tripled since the first half of the 1990s, when it was already widely viewed as excessive. Meanwhile, overall U.S. economic performance has faltered.

If the U.S. is to achieve growth that distributes income equitably and provides stable employment, government and business leaders must take steps to bring both stock buybacks and executive pay under control. The nation’s economic health depends on it.

From Value Creation to Value Extraction

For three decades I’ve been studying how the resource allocation decisions of major U.S. corporations influence the relationship between value creation and value extraction, and how that relationship affects the U.S. economy. From the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what I call “sustainable prosperity.”

This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.

As documented by the economists Thomas Piketty and Emmanuel Saez, the richest 0.1% of U.S. households collected a record 12.3% of all U.S. income in 2007, surpassing their 11.5% share in 1928, on the eve of the Great Depression. In the financial crisis of 2008–2009, their share fell sharply, but it has since rebounded, hitting 11.3% in 2012.

Since the late 1980s, the largest component of the income of the top 0.1% has been compensation, driven by stock-based pay. Meanwhile, the growth of workers’ wages has been slow and sporadic, except during the internet boom of 1998–2000, the only time in the past 46 years when real wages rose by 2% or more for three years running. Since the late 1970s, average growth in real wages has increasingly lagged productivity growth. (See the exhibit “When Productivity and Wages Parted Ways.”)

When Productivity and Wages Parted Ways

From 1948 to the mid-1970s, increases in productivity and wages went hand in hand. Then a gap opened between the two.

Not coincidentally, U.S. employment relations have undergone a transformation in the past three decades. Mass plant closings eliminated millions of unionized blue-collar jobs. The norm of a white-collar worker’s spending his or her entire career with one company disappeared. And the seismic shift toward offshoring left all members of the U.S. labor force—even those with advanced education and substantial work experience—vulnerable to displacement.

To some extent these structural changes could be justified initially as necessary responses to changes in technology and competition. In the early 1980s permanent plant closings were triggered by the inroads superior Japanese manufacturers had made in consumer-durable and capital-goods industries. In the early 1990s one-company careers fell by the wayside in the IT sector because the open-systems architecture of the microelectronics revolution devalued the skills of older employees versed in proprietary technologies. And in the early 2000s the offshoring of more-routine tasks, such as writing unsophisticated software and manning customer call centers, sped up as a capable labor force emerged in low-wage developing economies and communications costs plunged, allowing U.S. companies to focus their domestic employees on higher-value-added work.

These practices chipped away at the loyalty and dampened the spending power of American workers, and often gave away key competitive capabilities of U.S. companies. Attracted by the quick financial gains they produced, many executives ignored the long-term effects and kept pursuing them well past the time they could be justified.

A turning point was the wave of hostile takeovers that swept the country in the 1980s. Corporate raiders often claimed that the complacent leaders of the targeted companies were failing to maximize returns to shareholders. That criticism prompted boards of directors to try to align the interests of management and shareholders by making stock-based pay a much bigger component of executive compensation.

Given incentives to maximize shareholder value and meet Wall Street’s expectations for ever higher quarterly EPS, top executives turned to massive stock repurchases, which helped them “manage” stock prices. The result: Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.

Good Buybacks and Bad

Not all buybacks undermine shared prosperity. There are two major types: tender offers and open-market repurchases. With the former, a company contacts shareholders and offers to buy back their shares at a stipulated price by a certain near-term date, and then shareholders who find the price agreeable tender their shares to the company. Tender offers can be a way for executives who have substantial ownership stakes and care about a company’s long-term competitiveness to take advantage of a low stock price and concentrate ownership in their own hands. This can, among other things, free them from Wall Street’s pressure to maximize short-term profits and allow them to invest in the business. Henry Singleton was known for using tender offers in this way at Teledyne in the 1970s, and Warren Buffett for using them at GEICO in the 1980s. (GEICO became wholly owned by Buffett’s holding company, Berkshire Hathaway, in 1996.) As Buffett has noted, this kind of tender offer should be made when the share price is below the intrinsic value of the productive capabilities of the company and the company is profitable enough to repurchase the shares without impeding its real investment plans.

But tender offers constitute only a small portion of modern buybacks. Most are now done on the open market, and my research shows that they often come at the expense of investment in productive capabilities and, consequently, aren’t great for long-term shareholders.

Companies have been allowed to repurchase their shares on the open market with virtually no regulatory limits since 1982, when the SEC instituted Rule 10b-18 of the Securities Exchange Act. Under the rule, a corporation’s board of directors can authorize senior executives to repurchase up to a certain dollar amount of stock over a specified or open-ended period of time, and the company must publicly announce the buyback program. After that, management can buy a large number of the company’s shares on any given business day without fear that the SEC will charge it with stock-price manipulation—provided, among other things, that the amount does not exceed a “safe harbor” of 25% of the previous four weeks’ average daily trading volume. The SEC requires companies to report total quarterly repurchases but not daily ones, meaning that it cannot determine whether a company has breached the 25% limit without a special investigation.

Despite the escalation in buybacks over the past three decades, the SEC has only rarely launched proceedings against a company for using them to manipulate its stock price. And even within the 25% limit, companies can still make huge purchases: Exxon Mobil, by far the biggest stock repurchaser from 2003 to 2012, can buy back about $300 million worth of shares a day, and Apple up to $1.5 billion a day. In essence, Rule 10b-18 legalized stock market manipulation through open-market repurchases.

The rule was a major departure from the agency’s original mandate, laid out in the Securities Exchange Act in 1934. The act was a reaction to a host of unscrupulous activities that had fueled speculation in the Roaring ’20s, leading to the stock market crash of 1929 and the Great Depression. To prevent such shenanigans, the act gave the SEC broad powers to issue rules and regulations.

During the Reagan years, the SEC began to roll back those rules. The commission’s chairman from 1981 to 1987 was John Shad, a former vice chairman of E.F. Hutton and the first Wall Street insider to lead the commission in 50 years. He believed that the deregulation of securities markets would channel savings into economic investments more efficiently and that the isolated cases of fraud and manipulation that might go undetected did not justify onerous disclosure requirements for companies. The SEC’s adoption of Rule 10b-18 reflected that point of view.

Debunking the Justifications for Buybacks

Executives give three main justifications for open-market repurchases. Let’s examine them one by one:

1. Buybacks are investments in our undervalued shares that signal our confidence in the company’s future.

This makes some sense. But the reality is that over the past two decades major U.S. companies have tended to do buybacks in bull markets and cut back on them, often sharply, in bear markets. (See the exhibit “Where Did the Money from Productivity Increases Go?”) They buy high and, if they sell at all, sell low. Research by the Academic-Industry Research Network, a nonprofit I cofounded and lead, shows that companies that do buybacks never resell the shares at higher prices.

Where Did the Money from Productivity Increases Go?

Buybacks—as well as dividends—have skyrocketed in the past 20 years. (Note that these data are for the 251 companies that were in the S&P 500 in January 2013 and were public from 1981 through 2012. Inclusion of firms that went public after 1981, such as Microsoft, Cisco, Amgen, Oracle, and Dell, would make the increase in buybacks even more marked.) Though executives say they repurchase only undervalued stocks, buybacks increased when the stock market boomed, casting doubt on that claim.

Source: Standard & Poor’s Compustat database; the Academic-Industry Research Network.
Note: Mean repurchase and dividend amounts are in 2012 dollars.

 

Once in a while a company that bought high in a boom has been forced to sell low in a bust to alleviate financial distress. GE, for example, spent $3.2 billion on buybacks in the first three quarters of 2008, paying an average price of $31.84 per share. Then, in the last quarter, as the financial crisis brought about losses at GE Capital, the company did a $12 billion stock issue at an average share price of $22.25, in a failed attempt to protect its triple-A credit rating.

In general, when a company buys back shares at what turn out to be high prices, it eventually reduces the value of the stock held by continuing shareholders. “The continuing shareholder is penalized by repurchases above intrinsic value,” Warren Buffett wrote in his 1999 letter to Berkshire Hathaway shareholders. “Buying dollar bills for $1.10 is not good business for those who stick around.”

2. Buybacks are necessary to offset the dilution of earnings per share when employees exercise stock options.

Calculations that I have done for high-tech companies with broad-based stock option programs reveal that the volume of open-market repurchases is generally a multiple of the volume of options that employees exercise. In any case, there’s no logical economic rationale for doing repurchases to offset dilution from the exercise of employee stock options. Options are meant to motivate employees to work harder now to produce higher future returns for the company. Therefore, rather than using corporate cash to boost EPS immediately, executives should be willing to wait for the incentive to work. If the company generates higher earnings, employees can exercise their options at higher stock prices, and the company can allocate the increased earnings to investment in the next round of innovation.

3. Our company is mature and has run out of profitable investment opportunities; therefore, we should return its unneeded cash to shareholders.

Some people used to argue that buybacks were a more tax-efficient means of distributing money to shareholders than dividends. But that has not been the case since 2003, when the tax rates on long-term capital gains and qualified dividends were made the same. Much more important issues remain, however: What is the CEO’s main role and his or her responsibility to shareholders?

Companies that have built up productive capabilities over long periods typically have huge organizational and financial advantages when they enter related markets. One of the chief functions of top executives is to discover new opportunities for those capabilities. When they opt to do large open-market repurchases instead, it raises the question of whether these executives are doing their jobs.

A related issue is the notion that the CEO’s main obligation is to shareholders. It’s based on a misconception of the shareholders’ role in the modern corporation. The philosophical justification for giving them all excess corporate profits is that they are best positioned to allocate resources because they have the most interest in ensuring that capital generates the highest returns. This proposition is central to the “maximizing shareholder value” (MSV) arguments espoused over the years, most notably by Michael C. Jensen. The MSV school also posits that companies’ so-called free cash flow should be distributed to shareholders because only they make investments without a guaranteed return—and hence bear risk.

Why Money for Reinvestment Has Dried Up

Since the early 1980s, when restrictions on open-market buybacks were greatly eased, distributions to shareholders have absorbed a huge portion of net income, leaving much less for reinvestment in companies.

Note: Data are for the 251 companies that were in the S&P 500 Index in January 2013 and were publicly listed from 1981 through 2012. If the companies that went public after 1981, such as Microsoft, Cisco, Amgen, Oracle, and Dell, were included, repurchases as a percentage of net income would be even higher.

But the MSV school ignores other participants in the economy who bear risk by investing without a guaranteed return. Taxpayers take on such risk through government agencies that invest in infrastructure and knowledge creation. And workers take it on by investing in the development of their capabilities at the firms that employ them. As risk bearers, taxpayers, whose dollars support business enterprises, and workers, whose efforts generate productivity improvements, have claims on profits that are at least as strong as the shareholders’.

The irony of MSV is that public-company shareholders typically never invest in the value-creating capabilities of the company at all. Rather, they invest in outstanding shares in the hope that the stock price will rise. And a prime way in which corporate executives fuel that hope is by doing buybacks to manipulate the market. The only money that Apple ever raised from public shareholders was $97 million at its IPO in 1980. Yet in recent years, hedge fund activists such as David Einhorn and Carl Icahn—who played absolutely no role in the company’s success over the decades—have purchased large amounts of Apple stock and then pressured the company to announce some of the largest buyback programs in history.

The past decade’s huge increase in repurchases, in addition to high levels of dividends, have come at a time when U.S. industrial companies face new competitive challenges. This raises questions about how much of corporate cash flow is really “free” to be distributed to shareholders. Many academics—for example, Gary P. Pisano and Willy C. Shih of Harvard Business School, in their 2009 HBR article “Restoring American Competitiveness” and their book Producing Prosperity—have warned that if U.S. companies don’t start investing much more in research and manufacturing capabilities, they cannot expect to remain competitive in a range of advanced technology industries.

Retained earnings have always been the foundation for investments in innovation. Executives who subscribe to MSV are thus copping out of their responsibility to invest broadly and deeply in the productive capabilities their organizations need to continually innovate. MSV as commonly understood is a theory of value extraction, not value creation.

Executives Are Serving Their Own Interests

As I noted earlier, there is a simple, much more plausible explanation for the increase in open-market repurchases: the rise of stock-based pay. Combined with pressure from Wall Street, stock-based incentives make senior executives extremely motivated to do buybacks on a colossal and systemic scale.

Consider the 10 largest repurchasers, which spent a combined $859 billion on buybacks, an amount equal to 68% of their combined net income, from 2003 through 2012. (See the exhibit “The Top 10 Stock Repurchasers.”) During the same decade, their CEOs received, on average, a total of $168 million each in compensation. On average, 34% of their compensation was in the form of stock options and 24% in stock awards. At these companies the next four highest-paid senior executives each received, on average, $77 million in compensation during the 10 years—27% of it in stock options and 29% in stock awards. Yet since 2003 only three of the 10 largest repurchasers—Exxon Mobil, IBM, and Procter & Gamble—have outperformed the S&P 500 Index.

The Top 10 Stock Repurchasers 2003–2012

At most of the leading U.S. companies below, distributions to shareholders were well in excess of net income. These distributions came at great cost to innovation, employment, and—in cases such as oil refining and pharmaceuticals—customers who had to pay higher prices for products.

Sources: Standard & Poor’s Compustat database; Standard & Poor’s Execucomp database; the Academic-Industry Research Network.
Note: The percentages of stock-based pay include gains realized from exercising stock options for all years plus, for 2003–2005, the fair value of restricted stock grants or, for 2006–2012, gains realized on vesting of stock awards. Rounding to the nearest billion may affect total distributions and percentages of net income. *Steven Ballmer, Microsoft’s CEO from January 2000 to February 2014, did not receive any stock-based pay. He does, however, own about 4% of Microsoft’s shares, valued at more than $13 billion.

Reforming the System

Buybacks have become an unhealthy corporate obsession. Shifting corporations back to a retain-and-reinvest regime that promotes stable and equitable growth will take bold action. Here are three proposals:

Put an end to open-market buybacks.

In a 2003 update to Rule 10b-18, the SEC explained: “It is not appropriate for the safe harbor to be available when the issuer has a heightened incentive to manipulate its share price.” In practice, though, the stock-based pay of the executives who decide to do repurchases provides just this “heightened incentive.” To correct this glaring problem, the SEC should rescind the safe harbor.

A good first step toward that goal would be an extensive SEC study of the possible damage that open-market repurchases have done to capital formation, industrial corporations, and the U.S. economy over the past three decades. For example, during that period the amount of stock taken out of the market has exceeded the amount issued in almost every year; from 2004 through 2013 this net withdrawal averaged $316 billion a year. In aggregate, the stock market is not functioning as a source of funds for corporate investment. As I’ve already noted, retained earnings have always provided the base for such investment. I believe that the practice of tying executive compensation to stock price is undermining the formation of physical and human capital.

Rein in stock-based pay.

Many studies have shown that large companies tend to use the same set of consultants to benchmark executive compensation, and that each consultant recommends that the client pay its CEO well above average. As a result, compensation inevitably ratchets up over time. The studies also show that even declines in stock price increase executive pay: When a company’s stock price falls, the board stuffs even more options and stock awards into top executives’ packages, claiming that it must ensure that they won’t jump ship and will do whatever is necessary to get the stock price back up.

In 1991 the SEC began allowing top executives to keep the gains from immediately selling stock acquired from options. Previously, they had to hold the stock for six months or give up any “short-swing” gains. That decision has only served to reinforce top executives’ overriding personal interest in boosting stock prices. And because corporations aren’t required to disclose daily buyback activity, it gives executives the opportunity to trade, undetected, on inside information about when buybacks are being done. At the very least, the SEC should stop allowing executives to sell stock immediately after options are exercised. Such a rule could help launch a much-needed discussion of meaningful reform that goes beyond the 2010 Dodd-Frank Act’s “Say on Pay”—an ineffectual law that gives shareholders the right to make nonbinding recommendations to the board on compensation issues.

But overall the use of stock-based pay should be severely limited. Incentive compensation should be subject to performance criteria that reflect investment in innovative capabilities, not stock performance.

Transform the boards that determine executive compensation.

Boards are currently dominated by other CEOs, who have a strong bias toward ratifying higher pay packages for their peers. When approving enormous distributions to shareholders and stock-based pay for top executives, these directors believe they’re acting in the interests of shareholders.

That’s a big part of the problem. The vast majority of shareholders are simply investors in outstanding shares who can easily sell their stock when they want to lock in gains or minimize losses. As I argued earlier, the people who truly invest in the productive capabilities of corporations are taxpayers and workers. Taxpayers have an interest in whether a corporation that uses government investments can generate profits that allow it to pay taxes, which constitute the taxpayers’ returns on those investments. Workers have an interest in whether the company will be able to generate profits with which it can provide pay increases and stable career opportunities.

It’s time for the U.S. corporate governance system to enter the 21st century: Taxpayers and workers should have seats on boards. Their representatives would have the insights and incentives to ensure that executives allocate resources to investments in capabilities most likely to generate innovations and value.

Courage in Washington

After the Harvard Law School dean Erwin Griswold published “Are Stock Options Getting out of Hand?” in this magazine in 1960, Senator Albert Gore launched a campaign that persuaded Congress to whittle away special tax advantages for executive stock options. After the Tax Reform Act of 1976, the compensation expert Graef Crystal declared that stock options that qualified for the capital-gains tax rate, “once the most popular of all executive compensation devices…have been given the last rites by Congress.” It also happens that during the 1970s the share of all U.S. income that the top 0.1% of households got was at its lowest point in the past century.

The members of the U.S. Congress should show the courage and independence of their predecessors and go beyond “Say on Pay” to do something about excessive executive compensation. In addition, Congress should fix a broken tax regime that frequently rewards value extractors as if they were value creators and ignores the critical role of government investment in the infrastructure and knowledge that are so crucial to the competitiveness of U.S. business.

Instead, what we have now are corporations that lobby—often successfully—for federal subsidies for research, development, and exploration, while devoting far greater resources to stock buybacks. Here are three examples of such hypocrisy:

Alternative energy.

Exxon Mobil, while receiving about $600 million a year in U.S. government subsidies for oil exploration (according to the Center for American Progress), spends about $21 billion a year on buybacks. It spends virtually no money on alternative energy research.

Meanwhile, through the American Energy Innovation Council, top executives of Microsoft, GE, and other companies have lobbied the U.S. government to triple its investment in alternative energy research and subsidies, to $16 billion a year. Yet these companies had plenty of funds they could have invested in alternative energy on their own. Over the past decade Microsoft and GE, combined, have spent about that amount annually on buybacks.

Nanotechnology.

Intel executives have long lobbied the U.S. government to increase spending on nanotechnology research. In 2005, Intel’s then-CEO, Craig R. Barrett, argued that “it will take a massive, coordinated U.S. research effort involving academia, industry, and state and federal governments to ensure that America continues to be the world leader in information technology.” Yet from 2001, when the U.S. government launched the National Nanotechnology Initiative (NNI), through 2013 Intel’s expenditures on buybacks were almost four times the total NNI budget.

Pharmaceutical drugs.

In response to complaints that U.S. drug prices are at least twice those in any other country, Pfizer and other U.S. pharmaceutical companies have argued that the profits from these high prices—enabled by a generous intellectual-property regime and lax price regulation—permit more R&D to be done in the United States than elsewhere. Yet from 2003 through 2012, Pfizer funneled an amount equal to 71% of its profits into buybacks, and an amount equal to 75% of its profits into dividends. In other words, it spent more on buybacks and dividends than it earned and tapped its capital reserves to help fund them. The reality is, Americans pay high drug prices so that major pharmaceutical companies can boost their stock prices and pad executive pay.Given the importance of the stock market and corporations to the economy and society, U.S. regulators must step in to check the behavior of those who are unable or unwilling to control themselves. “The mission of the U.S. Securities and Exchange Commission,” the SEC’s website explains, “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Yet, as we have seen, in its rulings on and monitoring of stock buybacks and executive pay over three decades, the SEC has taken a course of action contrary to those objectives. It has enabled the wealthiest 0.1% of society, including top executives, to capture the lion’s share of the gains of U.S. productivity growth while the vast majority of Americans have been left behind. Rule 10b-18, in particular, has facilitated a rigged stock market that, by permitting the massive distribution of corporate cash to shareholders, has undermined capital formation, including human capital formation.

The corporate resource allocation process is America’s source of economic security or insecurity, as the case may be. If Americans want an economy in which corporate profits result in shared prosperity, the buyback and executive compensation binges will have to end. As with any addiction, there will be withdrawal pains. But the best executives may actually get satisfaction out of being paid a reasonable salary for allocating resources in ways that sustain the enterprise, provide higher standards of living to the workers who make it succeed, and generate tax revenues for the governments that provide it with crucial inputs.

A version of this article appeared in the September 2014 issue of Harvard Business Review.

Key Sources of Research:

Buybacks Around the World
Market Timing, Governance and Regulation

Alberto Manconi Urs Peyer Theo Vermaelen
September 2015

https://knowledge.insead.edu/sites/www.insead.edu/files/images/1bb_around_the_world_revised_-_september_8_2015-2.pdf

 

 

EXPLOITING EXCESS RETURNS FROM SHARE BUYBACK ANNOUNCEMENTS

White Paper by Catalyst Capital Advisors

http://www.catalystmutualfunds.com/i/u/6149790/f/Catalyst_Buyback_Strategy_White_Paper_2013-12-31.pdf

 

 

BUYBACKS: FROM BASICS TO POLITICS

WILLIAM LAZONICK
The Academic-Industry Research Network

August 19, 2015

http://www.theairnet.org/v3/backbone/uploads/2015/08/Lazonick-Buybacks-Basics-to-Politics-20150819.pdf

 

Investment Opportunities and Share Repurchases

Walter I. Boudry*
Jarl G. Kallberg
Crocker H. Liu

Current Version: 08 September 2009

http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1503&context=articles

 

The savvy executive’s guide to buying back shares

By Bin Jiang and Tim Koller
Mckinsey
2011

https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-savvy-executives-guide-to-buying-back-shares

 

 

The Real Effects of Share Repurchases

Heitor Almeida, Vyacheslav Fos, and Mathias Kronlund
University of Illinois at Urbana-Champaign

October 22, 2014

https://business.illinois.edu/halmeida/repo.pdf

 

Buybacks and the board: Director perspectives on the share repurchase revolution

Richard Fields, Tapestry Networks
August 2016

https://irrcinstitute.org/wp-content/uploads/2016/08/FINAL-Buybacks-Report-Aug-22-2016.pdf

 

 

 

The Cannibalized Company Part 2

How the cult of shareholder value has reshaped corporate America

By Karen Brettell, David Gaffen and David Rohde

http://www.reuters.com/investigates/special-report/usa-buybacks-pay/

 

 

The Cannibalized Company Part 1

How the cult of shareholder value has reshaped corporate America

By Karen Brettell, David Gaffen and David Rohde

http://www.reuters.com/investigates/special-report/usa-buybacks-cannibalized/

 

 

Corporate Buybacks and Capital Investment: An International Perspective

Joseph W. Gruber and Steven B. Kamin

20017

https://www.federalreserve.gov/econres/notes/ifdp-notes/corporate-buybacks-and-capital-investment-an-international-perspective-20170411.htm

 

 

The Case for Stock Buybacks

SEPTEMBER 15, 2017

https://hbr.org/2017/09/the-case-for-stock-buybacks

 

 

Profits Without Prosperity

FROM THE SEPTEMBER 2014 ISSUE

https://hbr.org/2014/09/profits-without-prosperity

 

 

Stock buybacks: From retain-and- reinvest to downsize-and-distribute

By William Lazonick

2015

 

https://www.brookings.edu/wp-content/uploads/2016/06/lazonick.pdf

Stock Market Indicators: S&P 500 Buybacks & Dividends

 

https://www.yardeni.com/pub/buybackdiv.pdf

 

 

 

 Buyback Quarterly

FACTSET
20016

https://insight.factset.com/hubfs/Buyback%20Quarterly/Buyback%20Quarterly%20Q3%202016_12.19.pdf

https://www.factset.com/websitefiles/PDFs/buyback

 

The Ugly Truth Behind Stock Buybacks

https://www.forbes.com/sites/aalsin/2017/02/28/shareholders-should-be-required-to-vote-on-stock-buybacks/#13b556ce6b1e

Advertisements

Low Interest Rates and Banks’ Profitability : Update July 2017

Low Interest Rates and Banks’ Profitability : Update July 2017

 

Please see my previous posts.

Impact of Low Interest Rates on Bank’s Profitability

Low Interest Rates and Banks Profitability: Update – December 2016

 

Since December 2016, there are several new studies published which study low interest rates and Banks profitability.

 

 

Liberty State economics – a Blog of New York Federal Reserve has published a new column in June 2017.

Low Interest Rates and Bank Profits

 

 

Reduced Viability? Banks, Insurance Companies, and Low Interest Rates

CFA Institute

2016

CFA Institute Blog: Low Interest Rates and Banks

 

 

Changes in Profitability for Primary Dealers since the Financial Crisis

Benjamin Allen

Skidmore College

2017

Changes in Profitability for Primary Dealers since the Financial Crisis

 

 

Deloitte Consulting has published a new report in 2017 on Bank Models viability in environment of low interest rates.

Business model analysis European banking sector model in question

 

THE EFFECT OF NEGATIVE INTEREST RATES ON EUROPEAN BANKING
July 7, 2016
International banker

 

https://internationalbanker.com/banking/effect-negative-interest-rates-european-banking/

 

 

Low interest rates place a strain on the banks

bank of Finland

2016

https://www.bofbulletin.fi/en/2016/2/low-interest-rates-place-a-strain-on-the-banks/

 

 

The profitability of EU banks: Hard work or a lost cause?

KPMG

October 2016

 

https://assets.kpmg.com/content/dam/kpmg/xx/pdf/2016/10/the-profitability-of-eu-banks.pdf

 

 

The influence of monetary policy on bank profitability

Claudio Borio

2017

http://onlinelibrary.wiley.com/doi/10.1111/infi.12104/abstract

 

 

Can Low Interest Rates be Harmful: An Assessment of the Bank Risk-Taking Channel in Asia

2014

Asian Development Bank

 

https://www.adb.org/sites/default/files/publication/31204/reiwp-123-can-low-interest-rates-harmful.pdf

 

 

Determinants of bank’s interest margin in the aftermath of the crisis: the effect of interest rates and the yield curve slope

Paula Cruz-García, Juan Fernández de Guevara and Joaquín Maudos

 

http://www.uv.es/inteco/jornadas/jornadas13/Cruz-Garcia,%20Fernandez%20and%20Maudos_XIII%20Inteco%20Workshop.pdf

 

 

Dutch Central Bank has published a new study in November of 2016 on Banks’ Profitability and risk taking in a prolonged environment of Low Interest Rates.

Bank profitability and risk taking in a prolonged environment of low interest rates: a study of interest rate risk in the banking book of Dutch banks

 

 

Net interest margin in a low interest rate environment: Evidence for Slovenia

Net interest margin in a low interest rate environment: Evidence for Slovenia

 

Global Financial Stability Report, April 2017: Getting the Policy Mix Right

IMF

2017

IMF Global Financial Stability Report April 2017

 

 

Negative Interest Rates: Forecasting Banks’ Profitability in a New Environment

Stefan Kerbl, Michael Sigmund

Bank of Finland

Negative Interest Rates: Forecasting Banks’ Profitability in a New Environment

 

 

Low Interest Rates and the Financial System

Remarks by Jerome H. Powell
Member Board of Governors of the Federal Reserve System
at the 77th Annual Meeting of the American Finance Association
Chicago, Illinois
January 7, 2017

https://www.federalreserve.gov/newsevents/speech/powell20170107a.pdf

 

 

Bad zero: Financial Stability in a Low Interest Rate Environment

Elena Carletti  Giuseppe Ferrero

18 June 2017

https://www.dnb.nl/en/binaries/paper%20Carletti_Ferrero_18June2017_tcm47-360758.pdf

Business Investments and Low Interest Rates

Business Investments and Low Interest Rates

 

Longstanding IS-LM macroeconomic framework says that low interest rates should result in higher investment (as the cost of capital for investments declines).  However, in practice it is not true.  Business Investment also depends on many other factors such as projections for economic growth, market growth,  and Industry/sector growth (in which a company operates).  Low Interest rates also indicate low economic growth environment.  In a low growth environment, having poor projections of future cash flows from new investments, companies can not justify domestic Investments if financial hurdle rates are not met.  

Corporations also may have attractive options for investment outside the country.  Free Trade agreements allow for business investments to move overseas for getting access to growing markets or for cost cutting reasons such as labor costs.

Instead of Investing in new capacity, companies are paying dividends, and buying back shares to boost share prices and doing acquisitions. Companies are using their own cash retained from earnings to pay dividends, buyback shares, and in some cases doing acquisitions. Debt-financed acquisitions are done through raising capital from capital markets.

Companies do not need to grow by new fixed investments when they can grow by acquiring other companies. Organic growth is the process of business expansion by increased output, customer base expansion, or new product development, as opposed to mergers and acquisitions, which is inorganic growth. Organic growth typically excludes the impact of foreign exchange.  

There has been spectacular M&A activity in 2014, 2015 and is continuing in 2016.  

In low economic growth and low interest rate environment, it may make more sense to grow by inorganic growth.  The justification for M&A is usually the combination of reduced costs of doing business and increased revenue from greater market share.   After completion of acquisition, acquiring company management may decide to rationalize business units – closing inefficient plants, laying off employees, combining overlapping internal corporate services departments.  These decisions depend on the type of M&A strategy.

Economists need to pay attention to these trends as well.  At present, there is no discussion of M&A activity in Economic Policy discourse among Economists and Policy makers.

 

Wall street data charts showing trends in Business Investments

na-cm077_resear_16u_20161026161806na-ck534_bizinv_16u_20160615183306

 

From  Jeff Cox / CNBC.com November 17 2016

Fed Chair Janet Yellen and her colleagues for quite some time have been bemoaning the low levels of business investment.

Pressed Thursday to explain why this has been the case, the central bank chief told Congress she wasn’t sure, but she denied it had anything to do with the Fed’s cheap-money policies of the past eight years.

“It’s not clear in my mind why it is that investment spending has been as weak as it is,” she told the Joint Economic Committee. “Initially, we had an economy with a lot of excess capacity. Firms were clearly operating without enough sales to justify a need to invest in additional capacity, and more recently with the economy moving toward full employment, we would expect to see investment spending pick up, and it’s not obvious exactly why it hasn’t picked up.”

Sen. Bill Cassidy, R-La., suggested that the fault may lie in what the Fed has done. Specifically, he pointed to the central bank’s quantitative easing measures that saw the Fed’s balance sheet surge to $4.5 trillion largely on three rounds of bond buying.

Faced with the uncertainty of returns from capital expenditures and the near-certainty of returns on assets like stocks and bonds during what Cassidy called “easy money” QE programs, businesses opted for the latter, he said.

“I wouldn’t agree that the Fed’s monetary policy has hampered business investment or been a negative factor,” Yellen responded. “I’m not aware of any evidence that suggests that it is.”

She explained that productivity has been on the decline since companies started reversing bare-bones employment levels during the financial crisis. However, that has not been met with business investment, in part because companies don’t believe it “will produce returns that justify those investments,” Yellen said.

 

From Moody.com

Moody’s: US non-financial corporates’ cash pile increases to $1.68 trillion, tech holding the lead

Global Credit Research – 20 May 2016

New York, May 20, 2016 — US non-financial companies rated by Moody’s held $1.68 trillion in cash at the end of 2015, up 1.8% from $1.65 trillion the year prior, Moody’s Investors Services says in a new report. The top 50 holders of cash account for $1.14 trillion of the total cash pile, and entry to the top 50 list now requires $6.12 billion in cash.

“The top four cash-heavy US industries remain technology, healthcare/pharmaceuticals, consumer products, and energy,” says Richard Lane, a Moody’s Senior Vice President. These four industries currently hold a record $1.3 trillion, or 77% of total corporate cash and have accounted for more than 72% of the total every year since 2007.

The top five cash holders are Apple, Microsoft, Google, Cisco Systems and Oracle, Moody’s says in “US Non-Financial Companies: Cash Pile Grows 1.8% to $1.68 Trillion; Tech Extends Lead Over Other Sectors.”

Apple held $215.7 billion in total cash for the period. The company has held the top spot as cash king since 2009.

“While the concentration of cash among the top-rated cash holders continues to grow, so too has the portion held by the technology sector, which accounted for a record 46% of total cash in 2015, up from 41% in 2014,” Lane says.

Moody’s expects the technology sector cash concentration will grind higher over the next year because of the sector’s strong cash flow generation and despite stronger returns of capital to shareholders. The technology sector generated 63% of the total rated non-financial free cash flow in 2015, up from 37% in 2007.

For the top 50, capital spending fell by 3% to $885 billion, and net share buybacks fell 7% to $269 billion. Dividends increased by 4% to a record high of $404 billion, while acquisition spending increased 43%, to a record $401 billion.

For the first time since 2012, cash coverage of aggregate debt maturities over the next five years fell below 100% to 93% at the end of 2015.

In 2016, Moody’s expects aggregate spending on capital investments, dividends, acquisitions and share buybacks to again approximate $1.9 trillion.

 

From Wall Street Journal

mi-cp973_divide_16u_20160603184210

 

From DealLogic

mw-dn118_ma_acq_20150602090958_mg

 

From M&A experts weigh in on deals for 2017

manda3manda2017

 

From  US M&A market on a high

us-ma-2015

From IMAA

usmabestusmabest2

 

Key ideas/issues for M & A:  

Why grow through M & A activities ?

  • Limited organic growth options
  • Need to address the transformation in the marketplace/existing business models
  • Availability of credit on favorable terms
  • Large Cash reserves/commitments
  • Shifting consumer demands
  • Improving Equity markets
  • Opportunities in emerging markets

What are concerns?

  • Slow growth environment
  • Lack of suitable targets
  • Record stock prices
  • Geopolitical risks
  • Others
  • Constrained Consumer Demand
  • Regulatory Considerations
  • Rising Interest Rates

 

 

Key terms:

  • Return on Investment (ROI)
  • Return on Invested Capital ( ROIC)
  • Internal Rate of Return (IRR)
  • Weighted Average Cost of Capital (WACC)
  • Economic Value added (EVA)
  • Return on Assets (ROA)
  • Return on Equity (ROE)
  • Net Present Value (NPV)
  • Compound Annual Growth Rate (CAGR)
  • Capital Expenditures ( CAPEX)
  • Corporate Savings Glut
  • Business Fixed Investments
  • Share Buybacks
  • DIvidends
  • Acquisitions
  • NAFTA
  • TPP
  • TTIP
  • International Investment Position (IIP)
  • Free Trade
  • Direct Investment Position (FDI)
  • Trade Flows
  • Current Account
  • Capital Account
  • Organic Growth
  • Inorganic Growth

 

 

Key Sources of Research:

 

Business Investment in the United States: Facts, Explanations, Puzzles, and Policies

Remarks by Jason Furman Chairman, Council of Economic Advisers

September 30, 2015

 

https://obamawhitehouse.archives.gov/sites/default/files/page/files/20150930_business_investment_in_the_united_states.pdf

http://www.progressivepolicy.org/wp-content/uploads/2015/09/2015.09.30-Jason-Furman_Business-Investment-in-US-Facts-Explanations-Puzzles-Policies.pdf

 

 

Firms’ Investment Decisions and Interest Rates

Kevin Lane and Tom Rosewall

http://www.rba.gov.au/publications/bulletin/2015/jun/pdf/bu-0615-1.pdf

 

 

Investing when interest rates are low

By Timothy M. Koller, Jiri Maly, and Robert N. Palter

http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/investing-when-interest-rates-are-low

 

 

Are low-interest rates contributing to low business investment?

By Nick Bunker

http://equitablegrowth.org/equitablog/are-low-interest-rates-contributing-to-low-business-investment/

 

 

Why isn’t Investment More Sensitive to Interest Rates: Evidence from Surveys

Steve A. Sharpe and Gustavo A. Suarez

2014

https://www.federalreserve.gov/econresdata/feds/2014/files/201402r.pdf

 

 

Why Aren’t Low Rates Working? Blame Dividends

Since the Federal Reserve took rates to near zero, companies have boosted buybacks 194%

http://www.wsj.com/articles/why-arent-low-rates-working-blame-dividends-1465119005

 

 

Low Interest Rates Are Hurting Growth

http://www.forbes.com/sites/realspin/2016/10/04/low-interest-rates-are-hurting-growth/#5e9ccf813a2b

 

 

Secular Stagnation and Returns on Capital

Paul Gomme,  B. Ravikumar, Peter Rupert,

https://files.stlouisfed.org/research/publications/es/15/ES_19_2015-08-18.pdf

 

 

The Return to Capital and the Business Cycle

Gomme, Paul, B. Ravikumar, and Peter C. Rupert, 2006.

Federal Reserve Bank of Cleveland, Working Paper no. 06-03.

https://www.clevelandfed.org/en/newsroom-and-events/publications/working-papers/working-papers-archives/2006-working-papers/wp-0603-the-return-to-capital-and-the-business-cycle.aspx

 

 

Long-term investment, the cost of capital and the dividend and buyback puzzle

Adrian Blundell-Wignall and Caroline Roulet

https://www.oecd.org/finance/Long-term-investment_CapitalCost-dividend-buyback.pdf

 

 

The “Search for Yield” and Business Investment

By Jason M. Thomas

https://www.carlyle.com/sites/default/files/market-commentary/productivity_slowdown_may2016_final.pdf

 

 

Infrastructure versus other investments in the global economy and stagnation hypotheses: What do company data tell us?

Adrian Blundell-Wignall and Caroline Roulet*

https://www.oecd.org/investment/Infrastructure-versus-other-investments-Global-economy-Stagnation-hypotheses.pdf

 

 

(Why) Is investment weak?

Ryan Banerjee Jonathan Kearns Marco Lombardi

http://www.bis.org/publ/qtrpdf/r_qt1503g.pdf

 

 

The Fed Has Hurt Business Investment

by Michael Spence, Kevin Warsh

http://www.hoover.org/research/fed-has-hurt-business-investment

 

 

FRED data series on Savings and Investments

https://fred.stlouisfed.org/categories/112

 

 

Weak Business Investment, Lower Neutral Rate Impacting Each Other

http://www.theepochtimes.com/n3/2160321-weak-business-investment-lower-neutral-rate-impacting-each-other/

 

 

The Corporate Saving Glut in the Aftermath of the Global Financial Crisis

Joseph W. Gruber and Steven B. Kamin

https://www.federalreserve.gov/econresdata/ifdp/2015/files/ifdp1150.pdf

 

 

Rising Intangible Capital, Shrinking Debt Capacity, and the US Corporate Savings Glut

Antonio Falato Dalida Kadyrzhanova Jae W. Sim

November 2012. This version: June 2013

http://www.cepr.org/sites/default/files/events/papers/5599_KADYRZHANOVA_Cover%20-%20Rising%20Intangible%20Capital,%20Shrinking%20Debt%20Capacity%20and%20the%20US%20Corporate%20Savings%20Glut.pdf

 

 

Corporate Profits and Business Fixed Investment: Why are Firms So Cautious about Investment?

Naoya Kato and Takuji Kawamoto

April 2016

https://www.boj.or.jp/en/research/wps_rev/rev_2016/data/rev16e02.pdf

 

 

The Evolution of Corporate Cash

John R. Graham
Mark T. Leary

Draft: February 2015

http://www.rhsmith.umd.edu/files/Documents/Departments/Finance/seminarspring2015/graham.pdf

 

 

Adverse Effects of Ultra-Loose Monetary Policies on Investment, Growth and Income Distribution

Andreas Hoffmann & Gunther Schnabl

http://www.savings-banks.com/SiteCollectionDocuments/Savings%20and%20Investment%20During%20the%20Great%20Depression%20and%20the%20Recent%20Global%20Crisis.pdf

 

 

NAFTA at 20

AFL-CIO

http://www.aflcio.org/content/download/121921/3393031/March2014_NAFTA20_nb.pdf

 

 

The North American Free Trade Agreement (NAFTA)

 

M. Angeles Villarreal

Ian F. Fergusson

April 16, 2015

https://fas.org/sgp/crs/row/R42965.pdf

 

 

 

NAFTA Revisited

PIIE

http://big.assets.huffingtonpost.com/NAFTA_Revisited_Text.pdf

 

Direct Investment Positions for 2015 Country and Industry Detail

 

By Derrick T. Jenniges and James J. Fetzer

July 2016

 

http://www.bea.gov/scb/pdf/2016/07%20July/0716_direct_investment_positions.pdf

 

 

Activities of U.S. Multinational Enterprises in the United States and Abroad

Preliminary Results From the 2014 Benchmark Survey

 

http://www.bea.gov/scb/pdf/2016/12%20December/1216_activities_of_us_multinational_enterprises.pdf

 

 

2015: A Merger Bonanza
Nearly $5 trillion worth of deals were announced last year. Why do so many big companies want team up?

http://www.theatlantic.com/business/archive/2016/01/2015-mergers-acquisitions/423096/

 

 

M&A experts weigh in on deals for 2017

https://info.kpmg.us/ma-survey-2017.html?gclid=Cj0KEQiAkO7CBRDeqJ_ahuiPrtEBEiQAbYupJaJUqUI61s1m-kFVDnT112-3ocH1SdVfcCxiBiNX614aAuvj8P8HAQ

 

 

 

The Federal Reserve’s Impact on the US M&A Market: An Empirical Examination

Sebastian v. Boetticher

Spring 2015

 

http://www.cob.calpoly.edu/undergrad/files/2015/09/Boetticher.pdf

 

 

M&A Statistics

IMAA offers extensive and up-to-date information, data, research on M&A and Mergers & Acquisitions statistics

https://imaa-institute.org/mergers-and-acquisitions-statistics/

 

 

Hearing: The Economic Outlook

Janet Yellen on November 16 2016 speaking at Joint Economic Committee

Listen/view at 1:33:00 her comments on Business Investments