What we would do if we wanted to reduce America’s excessive share repurchasing problem.

September 11th, 2014 at 6:14 pm

You’ve hopefully heard about, if not read, this revealing analysis by William Lazonick on the sharp rise in public corporations using their profits to boost their share price through stock buybacks as opposed to re-investment.

I won’t summarize the findings, as Harold Meyerson amply does so here. As he writes:

From the end of World War II through the late 1970s major U.S. corporations retained most of their earnings and reinvested them in business expansions, new or improved technologies, worker training and pay increases. Beginning in the early ’80s, however, they have devoted a steadily higher share of their profits to shareholders.

Lazonick looked at the 449 companies listed every year on the S&P 500 from 2003 to 2012. He found that they devoted 54 percent of their net earnings to buying back their stock on the open market…they devoted another 37 percent of those earnings to dividends. That’s a total of 91 percent of their profits that America’s leading corporations targeted to their shareholders, leaving a scant 9 percent for investments, research and development, expansions, cash reserves or, God forbid, raises.

What I wanted to tackle here is a question someone asked me the other day: what could be done about this significant problem of underinvestment in the long-term in the interest of boosting near-term share prices, stock options, and stock-based CEO pay?

Lazonick offers three ideas.

First, change back the SEC rule that facilitated the growth of stock repurchases. Back in the early 1980s the SEC gave corporate leaders the permission to repurchase large amounts of their companies’ outstanding shares, with only nominal oversight against stock price manipulation. Lazonick suggests the SEC change the rule back to sharply limit allowable repurchases.

Second, put some restrictions on stock-based compensation. For example, implement a six-month holding period for exercised stock options so executives can’t immediately flip shares when a buyback spikes the price.

Third, implement corporate governance changes that give some different stakeholders seats on the board, like worker representatives. This is a common German practice, and their corporations certainly plough more profits back into their companies than ours do (though this is but one of many difference in governance and corporate culture).

I’d add: do not provide government subsidies and tax breaks to companies that engage in large scale and frequent open market repurchases (as opposed to “tender offers,” which tend to be smaller, less frequent, and more benign). If the best use you can think of for your retained earnings is dividend payouts and share buybacks, why should the taxpayer subsidize your R&D or equipment purchases?

Pfizer and other American drug companies defend their patents and profits by saying how essential they are for research. Yet from 2003-12, they spent 146% (!) of their net income on dividends and buybacks. I should also note here that Pfizer paid 3% of its worldwide income in taxes in 2012. If reading that makes you feel like a tax-paying chump who neglected to get lawyered up, join the club.

Finally, the fact that tax rates on dividends and capital gains are lower than those on ordinary income exacerbates this problem.

And no, none of these sorts of changes are likely to occur anytime soon. But when you think about how these regulatory and tax issues have facilitated this short-sighted trend—one which exacerbates inequality and slows investment-led growth—you get an important insight into ways policy changes shape economic outcomes.

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9 comments in reply to "What we would do if we wanted to reduce America’s excessive share repurchasing problem."

  1. Tiree says:

    To be totally honest, I’ve never understood this trend of repurchasing shares. I really don’t understand the purpose, the ramifications or the detriments.

    I don’t understand why a company would ever engage in such a thing. It doesn’t make sense to me at all. Why should a company ever do this? I’m obviously just financially stupid. It isn’t a course of action I’d ever imagine would seem reasonable.

    This all seems like a game for a different breed of people.


    • mitakeet says:

      I have been studying business for over 35 years and I can tell you _exactly_ why corporations buy back stock: it makes the executives richer. In ‘old style’ companies executives were rewarded when the company grew market share, increased profits, decreased costs or brought new products to market. Today executives are rewarded almost exclusively when stock prices rise (interestingly, they are never penalized when stock prices go down; ‘it is outside of our control’). Since executives are rewarded by increase in stock price, naturally they are incentivised to do anything in their power to jack that price up, grab the rewards and start looking around for new ways to jack the price up. I read a bizarre case in MBA school where a company had actually incentivised their executives to destroy the company by selling all the company’s assets. Is it any wonder that the company ceased to exist in a year or two?

      It is indeed a game, and much like any other game for the 1%, the rest need not apply. Executive leadership positions are largely filled based on their parents, which schools they attended and the people they hang out with. Actual qualifications are generally dead last in any consideration. It is now a rare (large public) company that is operated for the long haul, most are operated quarter by quarter. The idea of making a long-term investment that, if successful, would pay off huge for the company is considered foolhardy by most executives today. Given the longevity of most executives all they would be doing is enriching their successor (or successor’s successor), it would do nothing for themselves.

      How to reverse this? I could write a book, but ultimately nothing will change unless shareholders want to make changes and since the vast majority of shareholders today are either short-term thinking (just like the executives) or totally ignorant (how many trillions of shares are in 401Ks and pensions?), overcoming the mountain of road blocks put in place by the executives against shareholder ‘activism’ (it amazes me that executives get away with this sort of stuff) is a fools errand.


      • Tiree says:

        I guess this is why I never understood it. Because it doesn’t fit the purpose of a corporation. I only worked for 1 company that engaged in this practice over the years, and it was a bad company to work for. The CEO was very famous, constantly on the road selling the companies’ stock, and he treated his employees like garbage. This company was very rich, and it has since closed its branch in my home state. It always treated people like garbage regardless of profits.

        He was a jerk. I guess it was a problem for them when I quit my job and told my boss that I thought the CEO was a jerk. He looked at me like I was an alien, and then he formed a meeting to turn all of the employees against me. He told them I was mentally ill and they believed it. Today, this is the definition of mentally ill: call your CEO a jerk.

        This country is in serious trouble.


  2. DG says:

    So, Jared, if I understand the argument correctly, we want to see corporations who understand they don’t have a use for the capital they have accumulated to go and find a use for that capital anyway — even if the use is to buy a bigger jet for the CEO?

    Despite your observation regarding drug companies — highlighting an entirely different issue to good effect — as an investor I like to see share buybacks. It’s a signal to me that it’s time to reallocate my capital away from the investment that has signaled lower future returns on its invested capital. And to invest the proceeds into companies with higher future (potential) returns on invested capital.

    And, in general, stock buybacks and high dividend rates are the corporate predictors of secular stagnation. The behavior investor Larry Fink despairs is entirely consistent for an operator CEO to pursue in the face of prolonged weakness in demand and soft labor markets. Why invest for the future if you have more productive capacity than you need? (Note the survey covers S&P500 companies that have ready access to capital should they need it — they have the ability to respond to the increase in demand when it occurs.)

    Share repurchases are at the tail end of the chain of economic causality, not the start.


  3. Robert buttons says:

    Companies, besides holding record cash (or maybe because of) are also holding record debt. End ZIRP and you end buybacks.


  4. Another Scott says:

    Cui bono?

    There’s little doubt that too many of the incentives for corporate behavior by management are counterproductive for society at large, and often for the corporation itself. The upper management does very well though, as designed.

    If rules about share-bybacks are tightened up, I hope the lawmakers and regulators who draw up and enforce the new rules carefully study the recent example of Apple using borrowed money to increase their dividend and buy back shares, rather than using their vast mountain of accumulated profits. That is just nuts from an intuitive point of view, but the tax laws, etc., enable them to do it at lower cost. (Don’t accept the argument that “it only makes sense because interest rates are so low, etc., etc.” There will always be extenuating circumstances that can be twisted by clever lawyers and accountants. That’s their job after all.)

    Corporate managers and lawyers are very clever. They benefit by being clever. Make sure any new rules don’t open up even larger loopholes.

    My $0.02.

    Cheers,
    Scott.


  5. John Daschbach says:

    As with everything in Economics the there are a multitude of factors and when I see people taking simple minded approaches to something complex I realize they are not thinking critically. There are many factors which influence the trend in higher non-wage compensation including tax law changes, pension structure, mean lifetime job tenure, globalization, technology change rates, intelligence premiums, ….

    These are not orthogonal basis functions but all contribute to the change we have seen over the past few decades. At the individual level, tax law changes increased non-wage compensation, but this isn’t just the CEO’s. All of my friends in high-level technical, low level executive positions (people with PhD’s who are technical group leaders, group research directors, etc., with good, but non-executive total compensation ($350K – $600K) tell me they receive 1/2 of that in non-wage compensation. All but one have been through multiple buyouts, massive restructuring, having to layoff large parts of their groups, etc. and all understand that any position is very temporary. In such an environment, a large part of compensation comes through bonuses, which under current tax structure are paid almost entirely in stock. The positive result of this is much less wage-stickyness and employment flexibility. If your base pay is $250K and stock bonus compensation is $250K (typical PhD level group research director level) you are much more willing to flexibly move to another company with better long term thinking (and corresponding stock compensation) than if your paid $450K with a $50K cash bonus.

    So it’s not just at the CEO level, it’s at the level where real innovation and productivity is occurring. Technically innovative people want to work in technological innovation. The current compensation structure generally rewards this (look at the current Silicon Valley).

    There are negatives as well. But it’s not a black and white issue.

    I think Brad DeLong’s comment about compensation eventually going to those who are really smart or creative, or who have great smiles, has more that a little truth in it. In a world where most production goes towards “wants” and not “needs” the premium for being able to supply “wants” goes up. That is the world we live in.

    Society can only counter this by changing it’s understanding of this. The free market is poorly equipped to deal with this. We all want people to have fair compensation for their real productivity, but how many people who think this way actually pay their maid/gardener/nanny/… more than their neighbors for the good of the economy?


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